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Credit Roundtable: Finding Opportunities Requires Patience and Persistence

Portfolio Managers Tracy Chen and John McClain along with Associate Portfolio Manager & Senior Research Analyst Kevin O’Neil join Senior Vice President – Investment Specialist Katie Klingensmith in a panel discussion on global credit markets. While they see several challenges ahead in 2024, they also are finding attractive opportunities through a combination of top-down macroeconomic analysis, bottom-up fundamental research—and a fair amount of patience.

How much is the Federal Reserve influencing credit markets?

According to John McClain, markets have been hanging on Federal Reserve (Fed) Chair Jay Powell’s every word. And with the recent shift in the Fed’s tone, expectations may be coming around to the idea that interest rates may be higher for longer. With a soft landing, helped by the continued resilient economic data, there would be no reason to expect the Fed to implement five or six rate cuts.

What has the current corporate earnings season revealed?

Roughly halfway through earnings season, the results have been mixed, suggesting some caution may be warranted. Higher rates and heightened geopolitical strains may present challenges for risk assets like credit.

In the current environment, fundamentals matter as the cost of capital is materially higher for companies. Businesses are borrowing less, which we believe is a meaningful tailwind for corporate credit, both in investment grade and in high yield. However, valuations also matter. While the economic backdrop may be positive, investors need to be cautious of stretched valuations. With the inverted curve and strong front-end yields, it pays to be patient right now.

How is the health of U.S. housing and households?

Tracy Chen sees an imbalanced U.S. housing market. On one hand, the market is partially frozen, with very depressed housing activity. Existing homeowners are locked in by earlier low mortgage rates while first-time homebuyers are locked out because of high rates and poor home affordability.

However, housing prices have been quite resilient, and household balance sheets have remained healthy. Along with some pent-up demand, these factors should support the housing market going forward.

Where do we see opportunities in structured credit?

Since last year, valuations in agency residential mortgage-backed securities (RMBS) have become cheap. Their biggest buyers, the Fed and banks, have mostly exited the market, due to quantitative tightening (QT) and banking regulations. Meanwhile, the heightened rate volatility is extremely unfavorable to the mortgage market. These conditions have turned the negative convexity—which is notorious for mortgage-backed securities—the least negative in the sector’s history. However, with the Fed expected to commence its interest rate cutting cycle, we believe interest rate volatility should decrease, boosting MBS valuations.

Additionally, there are several favorable fundamental and technical factors that should work well for the credit risk transfers (CRT) market, including a handsome coupon carry, credit rating upgrades, and negative net supply. Furthermore, these securities tend to be an attractive hedge for a rate selloff.

Meanwhile, the commercial real estate market has been at the epicenter of a perfect storm of interest rate sensitivity and post-pandemic excess office supply. However, commercial mortgage-backed securities (CMBS) are not all about offices, says Tracy Chen. There are diversified property types in the CMBS market, including multifamily, retail, hotel, industrial, and self-storage. Each property sector has its own idiosyncratic characteristics. Although headline risk continues to be an almost-daily source of volatility, the cap rate is not cheap, and price transparency is limited, the extremely negative market sentiment in the CMBS market may be overdone.

What issuance trends are you seeing in corporate credit?

January saw historic levels of issuance in investment grade credit. As Kevin O’Neil highlights, what is more significant than the maturity walls is the demand for capital. Looking at one measure of demand, new issue concessions, the average concession was just around 3.5%, even with January’s large supply. To put that in context, last year's average concession was about 8 to 9 basis points. Not only is there huge issuance currently, but there is strong demand from the investment community now that the Fed appears to have reached peak rates.

High yield is seeing similarly strong issuance and demand. One of the key trends that we may see in 2024 is private credit deals refinanced into the broadly syndicated market, whether that is bonds or loans. Additionally, more floating-rate paper may be put into the fixed-rate market. If high yield bonds take share from leveraged loans, that likely will create more seniority and more secured paper in the high yield asset class.

What are the liquidity and issuance dynamics in securitized credit?

While issuance has been somewhat better than last year, net supply remains modest. However, limited net supply presents an attractive market technical for the securitized space. In terms of the credit curve, it has flattened materially since the Fed pivot last year.

To summarize, what are the major opportunities and themes expected across credit markets this year?

Within corporate credit, valuations are stretched; it will not take much bad news to see spreads moving wider. Hence, we expect bouts of volatility in the marketplace. There is a lot of angst around a number of situations, but the carry is still interesting. So, it goes back to being paid to be patient, waiting for opportunities as they present themselves, and deploying capital aggressively into them.

In the securitized space, the agency MBS sector has the least negative convexity in its history. CRT bonds also boast a good convexity story. Other sectors we favor include subprime auto ABS and CMBS triple B; these segments have positive convexity because they are all trading at a discount.

Regarding the overall macro environment, the market is pricing in a high probability of a soft landing. However, both spreads and equities already reflect this view, limiting the upside potential. Instead, better value may be found by taking advantage of opportunities where not everything is priced in. This approach does not necessarily call for a hard landing, but rather looking for places where investors may not all be on the same page.

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Groupthink is bad, especially at investment management firms. Brandywine Global therefore takes special care to ensure our corporate culture and investment processes support the articulation of diverse viewpoints. This blog is no different. The opinions expressed by our bloggers may sometimes challenge active positioning within one or more of our strategies. Each blogger represents one market view amongst many expressed at Brandywine Global. Although individual opinions will differ, our investment process and macro outlook will remain driven by a team approach.