From Fraser Lundie, Head of Fixed Income – Public Markets, Federated Hermes Limited
Amid the significant uncertainty facing corporate credit investors today, several bright spots remain. So-called ‘Rising Stars’ – where credit quality and ratings are transitioning from High Yield to Investment Grade – are undoubtedly one of these, and at this stage of the cycle, this is an area of the fixed income spectrum which could provide an important source of alpha for investors.
Indeed, at the most recent count, this cohort outnumbered their counterparts going in the other direction – ‘fallen angels’. This is somewhat surprising given the broader economic outlook. Tighter policy has raised the cost of borrowing and lending standards have tightened, both of which have curtailed the supply of credit and constrained economic activity. Indeed, the IMF has projected that the global growth slowdown overall this year will be significant, falling from 2.7 percent in 2022 to 1.5 percent in 2023. Second quarter earnings have indicated a notable slowdown in cyclical and consumer sensitive sectors, with chemicals, paper and consumer electronics particularly weak.
Balance sheets remain robust, but credit metrics are starting to deteriorate. With weaker earnings and 2025 maturities approaching, issuers will need to begin addressing this – and access to capital is key.
Strong and getting stronger
Exploiting the opportunity set amongst potential Rising Stars requires an in-depth knowledge of the market and a bottom-up approach. Credit analysis offers insights into the many triggers that can cause a bond’s rating to change and aids our ability to distinguish investment candidates from those that could begin to deteriorate, both in terms of rating and performance. We also interrogate management’s policy when it comes to rewarding shareholders at the expense of prudent financial discipline – a common late-cycle red flag.
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At a time where growth concerns are building, and margin pressure through cost inflation has been a theme for some time, identifying credits that remain on a positive trajectory should be a rewarding offset to a challenging macro backdrop. In recent quarters, technology giant, Netflix, retailer Macy’s and integrated energy company EQT, have all graduated to Rising Stars status. We have seen their strength fully recognised by rating agencies, significant improvements to their free cash flow generation whilst reducing leverage. They have also been proactive in refinancing upcoming debt, terming out the liability term structure and lowering their cost of capital.
We expect there could be further examples to come into 2024, with several candidates currently sitting on “positive outlook” at the rating agencies – a precursor for some to a rating upgrade. Additionally, rating agencies tend to want to see sustained credit metric improvement before acting, and so the passage of time will naturally aid further rising star activity amongst those already deemed to be on a positive trajectory.
More buyers than sellers
The potential reward is further bolstered by another less tangible, technical tailwind. The rising star transition brings with it benchmark eligibility and inclusion dynamics. The resultant passive demand that meets this change typically sees such securities very well sponsored with deep bids in the market in the subsequent months.
This effect is even more pronounced as the Investment Grade asset class is today standing on its own two feet in terms of relative value. This has seen the asset class return to favour, having been hampered by a decade of low interest rates which have made it difficult to compete against the growth of equities and strong dividend yields. Bonds can now take a role which is more akin to what it was in the past, namely balancing a portfolio but also providing a competitive yield. For issuers, becoming a member of this club is therefore seemingly all the more attractive.
Active management at the core
Effective identification of rising star candidates should always be based on an active approach. Modelling out forward-looking projections of a company’s credit metrics is necessary to understand their financial robustness, while qualitative analysis is vital to understand the capital allocation policy, ESG and sustainability profile, and bring together a holistic, long-term view.
If the right approach is taken, ‘rising stars‘ could provide a source of optimism for credit investors, even as the fundamental outlook darkens.
