NOT TOO HOT, NOT TOO COLD: CREDIT LIKES GOLDILOCKS
Posted on January 27th, 2025
Goldilocks may have been more focused on porridge and a comfortable nap, but credit assets such as investment grade and high yield bonds as well as private credit loans also tend to perform best in a ‘just right’ environment, namely moderate economic growth and low/falling inflation. Happily this type of environment looks likely to persist into 2025. In this article, we explore the solid fundamentals behind credit assets and the impact easing interest rates could have on company managers’ ‘animal spirits’, to explain what could be in store for the asset class.
Credit markets have benefitted from historically high and relatively stable yields for the last two years, with credit risk spreads also remarkably stable. Falling yields helped fixed coupon and high duration bonds to deliver a second consecutive year of solid returns, for instance the Sterling Investment Grade bond index returned 8.6% in 2023 and 2.3% in 2024.
While there is some uncertainty about the timing of further central bank policy rate cuts, inflation concerns have reduced. Further cuts seem likely. In previous episodes where rate cuts have been delivered in a non-recessionary environment, credit spreads were largely unchanged 12 months later, suggesting another year of stability is in store.
Investment in credit assets in 2025 should continue to benefit from stable credit spreads, attractive starting yields and for fixed-rate bonds, the prospect of capital appreciation as base-rates are lowered over the course of the year.
Solid fundamentals
The financial buffers built up by many companies during the COVID shock have not yet been depleted so even though credit risk premia (the return over the risk-free yields of government bonds that investors demand for taking on credit risk) is close to 25-year lows they reflect better-than-average resilient balance sheets. Overall leverage metrics have remained well below historical norms across investment grade (IG) and high yield (HY) issuers. Meanwhile, earnings have been gradually improving, so even though interest expenses have picked up over the past year, interest coverage ratios have stabilised.
With central banks beginning to cut interest rates, funding costs are now declining, making refinancings less costly for issuers. Consumers will also benefit from lower mortgage costs as well as more affordable loans that could benefit issuers in retail and durable goods sectors.
This resilience is reflected in rating agency actions and in default rate expectations. Generally, corporates have enjoyed net ratings upgrades so far this year across IG and HY markets.
Default rates had been climbing in 2023 and into the early months of 2024 but peaked mid-year. In its 2025 forecast, Moody’s expects further gradual improvement, with HY loan and bond defaults dropping to 4.3% by the end of 2024 before declining further to below 3% by the end of 2025.
Source: Moody’s
Animal spirits rising
While some risks have faded with the growing conviction of an economic soft-landing, new risks are emerging. As borrowers gain more confidence that interest rates are easing and as valuations improve we are beginning to see “animal spirits” return. Companies are increasingly willing to prioritise actions that boost shareholder returns over balance sheet resilience.
We may see companies borrowing to pay a dividend which would limit upward rating momentum. For instance, for private equity funds looking to boost returns where it may be too early to IPO, a distribution is a good alternative for investments that have made good progress deleveraging or that feel confident enough in the economic outlook to reduce their resilience buffer.
Source: Moody’s Note: Rating Drift Calculation = (Notches upgrades – Notches downgrades) / Rated Issuers
Another “animal spirits” risk we are watching is a more broad-based mergers and acquisitions (M&A) cycle, which could weigh on credit metrics as benign markets can make companies more willing to sacrifice their credit rating to achieve a strategic goal.
If President Trump enacts all the policies he talked about while campaigning, further disruption is likely in 2025. We do not yet know the exact timing and scope of the policy measures to be adopted but the risk is that if large tariffs and mass deportations are implemented as described during the election campaign, they could weaken growth in the US and globally. By contrast a focus on lower taxes and less regulation may be favourable for growth and credit quality. While some proposed policies could stoke inflation, others are deflationary; some policies should boost growth, others could be negative. The timing, scale, and rhetoric of policy announcements could trigger numerous periods of market volatility.
“If President Trump enacts all the policies he talked about while campaigning, further disruption is likely in 2025…”
Tactical risks and opportunities
While high yields and stable economics favour a strategic allocation to credit markets, most sectors are already “priced to perfection” which limits the potential for further tightening of credit spreads. In this environment it will be important to maintain the ability to be tactical (keep an allocation to high quality liquid credit assets) because opportunities will arise to take advantage of volatile periods.
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