Research and Active Engagement: Credit upgrades dominate

 The below is an extract from our Q3 Active Fixed Income Outlook.

The past: What just happened?

Since we emerged from the COVID-19 pandemic, the fundamental quality of global credit markets has – on average – been on a consistently improving path. There was an initial rapid bounce back, followed by a more gradual, prolonged period of recovery.

Many originally investment grade (IG) companies that tipped into high yield (HY) territory during the pandemic (so-called fallen angels) subsequently recovered and made it back into IG indices in 2022 and 2023. Indeed, the trend of elevated rising stars has continued this year, hitting a post-COVID peak in February 2024 on a 12-month rolling basis.

The present: Idiosyncratic situations, not widespread downgrades

Analysing the percentage of BBB- bonds on negative outlook or watch (a common measure of credit downgrade risk) suggests that risk has recently picked up for global IG corporates, driven by negative outlooks on some large cap structures in the US. However, the largest of these are idiosyncratic situations suggesting that, unlike in previous waves of credit deterioration, sector-wide downgrades are not a significant risk.

That said, over the next 12-18 months, our analysts are predicting more fallen angels than at any point since COVID-19. We still expect these to be slightly outweighed by rising stars, so there will probably be marginally improving credit quality on average.

What could go wrong?

 In order to witness a more systematic deterioration in credit quality, we think a broad-based economic downturn would be needed. Our regular stress tests of the global credit investment universe suggest that over $350bn of IG bonds are vulnerable to downgrades in the event of a global recession.

To put this figure in context, this would be a slightly more benign outcome for bondholders than either the global financial crisis or the pandemic.

Outlook

Assuming that our base case of a soft landing remains intact, the bottom-up analysis conducted by our global research team concludes that we will continue to see more upgrades than downgrades over the next one to two years. That said, we expect this to be a bumpy ride and we believe the biggest improvements are behind us and will moderate from here.

Moreover, at compressed spread levels, the margin of error for IG investors is lower than usual. We believe avoiding problem credits is the best way to add alpha in a market environment such as this one, making single name selection more important than ever.

The above is an extract from our Q3 Active Fixed Income Outlook.