Although fundamentals will remain strong in 2022 (robust earnings growth, deleveraging, low defaults), the wave of global central bank liquidity is starting to retreat. We expect a deteriorating technical environment and expensive valuations to be the dominant drivers of spreads, with the ‘search for yield’ gradually beginning to reverse. We expect credit spreads to become more sensitive again to ECB-induced rates/QE uncertainties as we travel through 2022, which would be comparable to 2014-15 when the Fed tapered, or 2018 when the ECB tapered.
In European credit, we see spreads widening moderately as policy power fades on deteriorating technicals, but the fundamental backdrop remains very strong with the recovery from the pandemic still having room to run. Credit widening should be more moderate than in 2015 or 2018. We see 2022 as a story of liquidity reduction (policy tightening) while default risk remains low (stable growth), supply increases and demand suffers from the loss of QE support, but fundamentals remain healthy.
Solid fundamentals should cap any spread widening. We forecast 10bp of widening to 75bp in the iBoxx EUR IG NFC index (a level last seen in mid-2019 prior to the resumption of the CSPP) and 30bp of widening to 350bp in the iBoxx EUR NFC HY index, below the historical 3.5x beta relationship. As the economic environment will remain strong, however, we are only looking for modest, technically driven widening, rather than more significant weakness.
Credit ratings have stabilised, but they are not really improving. This year has not seen any material ratings uplift for investment-grade issuers despite the strong economic growth, as COVID-19 has become almost endemic, the protracted supply chain issues have pressured margins and profitability for some names, the acquisition cycle has accelerated much faster than after previous recessions, and credit agencies have been cautious about upgrading sectors more exposed to the ESG transition. Moody’s net ratings migration – reflecting upgrades minus downgrades as a percentage of the bonds rated by the agency – was barely positive on a 12-month rolling basis in October.
We expect upgrades across a broad range of sectors in 2022, accelerating in 2H22 once supply blockages begin to clear.
We forecast higher real interest rates as the Fed and ECB tighten policy. Historically, that has meant tighter borrowing conditions and wider spreads, but some credit assets should benefit, notably Financials (higher profit margins) and loans (floating-rate coupons and stable demand).
Higher EUR-denominated non-financial corporate issuance. On the supply side, we forecast EUR340bn gross/EUR195bn net of non-financial corporate issuance, +23% YoY and slightly above the 2019 aggregate level. Regarding corporates, the average cash/EBITDA ratio for EUR iBoxx NFC components is currently c.85%, so firms have therefore unwound about one-third of the cash war-chest accumulated since the pandemic began.
Five factors should drive NFC issuance up in 2022: i) higher redemption volume; ii) a strong increase in capex (for the energy transition, infrastructure, more localised supply chains, etc.); iii) declining excess cash; iv) shareholder-friendly actions rather than a reduction in the volume of outstanding debt, as activist and PE investors are jumping on European firms at a much faster pace; and v) an increase in acquisition financing (M&A, LBOs, etc.).
The main risks to our base scenario are: a) a more persistent pandemic (vaccine-resistant variants, failure to kickstart booster jab schemes); b) political risk (presidential elections in Italy and France, EU-Russia and US-China tensions, Brexit, midterm elections in the US, etc.); c) inflation (the transitory/persistence debate, a potential second-round impact driven by wages, etc.); d) ECB disappoints (more hawkish than expected, or too dovish if Omicron has a greater impact on economic activity than expected); e) China (real estate, domestic focus on deleveraging, decarbonisation, and a reduction in income inequality at the expense of weaker near-term growth); f) stagflation (unlikely in our view, unless supply disruptions prove more extensive and prolonged than we assume); g) market bubbles (crypto, technology stocks, etc.); and h) macro risks (supply problems in manufacturing, labour shortages, Omicron/winter COVID-19 wave, and the electricity (gas) price crisis ).
Main 2022 calls:
- In IG/Xover: reduce duration, trade up in rating quality, and trim exposure to subordinated paper. Elevated rates vol could lead to weaker flows into IG corporate bond funds in 2022. We prefer single-A names to BBBs as the latter benefited the most from QE. Heavier supply is likely to weigh on the long end and rising sovereign yields are likely to drag on total returns. Long-dated single-As may actually be defensive in a widening market, benefiting from the strongest demand (from insurers and pension funds).
- The ECB portfolio is concentrated in the belly of the curve (5-10Y). An ECB taper will reverse these effects, and therefore the extremes should outperform (3-5Y), while 10Y+ paper will be less owned by the ECB.
- Higher rates create competition for credit products. In our view, high-quality corporate debt is at the greatest risk of being "crowded out" in 2022, which would be a difficult time for CSPP-eligible spreads.
- Long domestic eurozone credits (ECB on hold) vs. EM-exposed exporters (EMs are aggressively hiking).
- CDS to outperform cash, reverse Yankees to outperform Europe-based issuers as they are not bought by the ECB and have a higher average rating.
- EUR IG to outperform GBP IG as the Bank of England will take the lead in rate hikes to combat increasing inflation expectations, and rising hedging costs could dent sterling credit’s appeal for foreign investors. The GBP IG’s relative value versus EUR IG also already looks stretched. We expect the iBoxx GBP IG Corporate index to widen by 25bp to 145bp.
- Financials – naturally defensive at this stage of the cycle and with less need to issue –should outperform IG Corporates in the senior space. They are less QE-dependent, have lower supply risk and no LBO risk, are fundamentally strong (low NPL levels) and are natural beneficiaries of higher yields and steeper curves. Attending to the traditional macro and volatility variables, the impact of the CSPP on the iBoxx non-financials senior index would be c.20bp as the CSPP holds c.27% of the total eligible debt.
- We expect ECB CSPP/PEPP corporate bond purchases to slow to EUR3bn net/EUR4.0bn gross from March 2022 vs. EUR6.5bn net/EUR8 bn gross in 2021. This would still be modestly supportive but roughly on par with the 2018 levels. The increased supply would come with wider new-issue premiums and lower oversubscription ratios. As corporates have almost deleveraged back to pre-pandemic levels, the ECB could conclude that less QE support is needed for corporate bonds.
- In the subordinated space, we would prefer AT1s and LT2 vs. NFC hybrids, as the latter might be vulnerable to a rise in interest rate volatility and the transition to a higher-yield environment. Hybrids have become a popular yield-enhancement tool among dedicated investment-grade portfolios, with PMs being OW in the asset class vs. the benchmark index.
- Within IG NFCs, we are still Overweight in sectors with cyclical exposure/services (the 2021 “laggards” with earnings still below pre-pandemic levels) or that are trading at a premium on ESG-transition concerns, exposure to a China recovery or limited exposure to ECB holdings, such as Services, Oil & Gas, Metals & Mining, Transport, Aerospace & Defence, and Real Estate. We expect these sectors to outperform those where the ECB is overbought, such as Telecoms, Utilities, Health Care and Retail.
- We would be Underweight Industrials, given low leverage and activist investor interest in European conglomerates.
- We expect EUR HY to outperform IG in total return terms. Low default risk, rising stars, lower supply risk and the extra carry benefit HY. The latter also offer protection from rates volatility vs. higher-quality parts of the market, where the deleveraging process is mostly done and dividend top-ups look necessary, given that Europe has lagged in terms of rebuilding shareholder pay-outs. Within EUR HY, we like BBs for Rising Star potential.
- Leveraged loans should outperform HY. They offer low default risk, attractive valuations vs. HY, a more stable investor base, strong demand and support from CLOs due to attractive arbitrage levels, and are a natural beneficiary of higher yields (floating rate, fund inflows), implying total returns of around 4%.