Credit markets were not immune to the macro volatility. Spreads widened substantially from 108 basis points at the beginning of the quarter to 143 at the end; although, the widening did not occur in a linear fashion. As shown in Figures 2 and 3, with spreads wider and yields higher, the Bloomberg US Credit Index posted a negative total return for the quarter, lagging similar duration Treasuries. Excess returns were negative across all sectors and maturities. Short and intermediate corporates outperformed their longer-dated counterparts. Looking at quality, BBBs underperformed higher quality AAAs, AAs, and As again this quarter. Non-corporate credit continued to outperform corporate credit, despite weakness in Sovereign debt. Within the corporate credit subsectors, Other Industrials and Construction Machinery relatively outperformed as these lower beta sectors fared better in market volatility. Essential Non-Cyclical Sectors also relatively outperformed, led by Consumer Products and Pharmaceuticals. Tobacco heavily underperformed as a series of regulations from the FDA continued to weigh on the sector. Gaming and Home Construction within Consumer Cyclicals were among the worst performing sectors as consumers slowed their consumption amidst rising prices.²

Looking at issuance in Figure 4, High Grade bond supply for the quarter was $269 billion. This was 23% lower than the second quarter of 2021 and 31% lower than the past four-year average.³

The Fed has also chosen to look at backwards and lagging data in their decision making, which will likely keep the voting members on a hawkish trajectory. The last minute and reactionary decision in the June meeting to go 75 basis points will only serve to increase market volatility around key data releases as market participants attempt to parse every piece of news in an attempt to divine how the FOMC will interpret it. Hardly an environment for stability and a critical policy mistake by Powell and team in our opinion. The market, however, may have other plans. Broad economic data has accelerated its descent faster than most have expected and is beginning to reprice the Fed. The July meeting, a lock for a 75 basis point increase just a few weeks ago, is now trending towards 50 basis points based on market pricing. Rates, as measured by the 10-year Treasury, have declined by over 60 basis points toward the end of the quarter after having come close to 3.5% only 2 weeks ago. Data such as retail sales, initial claims, regional manufacturing surveys, and inflation have softened and are picking up speed to the downside. Should the Fed raise 50 basis points in July and signal “normal” data dependent 25 basis point hikes after that, we would not be surprised to see a rather aggressive risk rally.⁵

Additionally, the draining of liquidity via quantitative tightening will likely only further increase volatility. Financial conditions have already increased faster than in the past 2+ decades outside of the GFC and the COVID-19 Pandemic, and the balance sheet reduction has barely begun.

It will also be important to factor in unemployment and the Fed’s dual mandate going forward. Jobless claims, as shown in Figure 8, is a leading indicator and has started to gradually uptick over the quarter.

Already this year the corporate index OAS has gapped wider only to recover to higher lows twiAlready this year the corporate index OAS has gapped wider only to recover to higher lows twice and is currently on its third bout of widening to wider wides. We see no reprieve from this pattern in the intermediate term. Absent a recession, the chances of which are quite high, we would expect spreads to range between +125 and +175 OAS in this volatile pattern. Depending on the depth of the impending recession, spreads could approach +200 OAS or wider. U.S. High Yield has exhibited a similar patten and is closing in on a 9% yield.

Corporate credit metrics are deteriorating. Although coverage ratios and corporate balance sheets are still relatively healthy, leverage is beginning to tick higher and we feel coverage ratios will decline with the increase in interest costs. The recent high profile profit warnings from major retailers are likely just the start of a more insidious pattern we expect to hear about with the round of second quarter earnings releases. In fact, as shown in Figures 10 and 11, supply chains are easing, and inventory is building.

Additionally, the inflationary environment has caused consumers to increase borrowing to maintain their consumption and living standards. As demonstrated in Figures 12-14, higher prices for gas, food, and housing are taking their toll on consumers and savings cushions have been significantly reduced, especially for those in lower income brackets who are more apt to live paycheck to paycheck. Consumer sentiment is the lowest ever and US home sales are plunging as borrowing rates have spiked.

While consumption metrics such as TSA throughput and OpenTable dining still show strong US consumption, we note many of those plans were made long ago and we expect some weakness in this data to come soon.

This will have a direct impact on corporate spread sectors such as Consumer Cyclicals, Technology, and Capital Goods. The balance of 2022 will require extreme caution by lenders in credit selection. While the above commentary is dire, we suggest the credit markets have priced in a substantial portion of the negative news and there are pockets of value and opportunity for fixed income investors. Value, as measured by yield and shown in Figure 17, is actually available in the market again after a long, QE suppressed slumber. Due to flat corporate credit curves on a flat Treasury curve, we feel attractive yields can be had without having to take significant duration risk. Corporates maturing inside of 5 years yield north of 4% with just a 2.7-year duration.⁶ Even if short rates continue to rise (not our view), corporate investors will have attractive reinvestment opportunities quickly.

Flat credit curves and flat yield curves also offer investors the opportunity to shift exposures without incurring large yield changes in portfolios. There are many situations that allow investors to shorten issuer exposure without having to give up yield, possible even increasing yield depending on issuer liquidity.

We have historically been quite active in the debt capital primary markets, but this year, we have been markedly less active. Issuance trends have slowed, leading many forecasters to lower their predictions for 2022 new issuance for both Investment Grade and High Yield corporates. In fact, as shown in Figure 18, the first half of this year saw more days of no new bonds issued since 2008 - certainly a byproduct of the aforementioned volatility. With capital markets intermittently closed, price discovery is poor, and we tend to see new bonds performing poorly. As a result, we expect our sources of idea generation in new issuance to remain relatively depressed for the remainder of the year.

Our risk remains at the low end of historical ranges. Due to the extreme flattening of the yield curve, we continue to find value in short-dated corporates that carry yields not seen in years. Alternatively, out the curve, and also due to the rapid rise in long term rates combined with low coupons of issuance the past few years, there are many securities trading at deep discount prices. Overall, we favor both high yielding, short duration bonds and low dollar price, longer duration corporates as attractive in the current environment. In terms of sector positioning, we are generally cautious around those sectors and names that are likely to face profitability pressures amid a slowdown in consumer spending.

Endnotes
¹ Bloomberg
² Bloomberg
³ Bloomberg
⁴ Bloomberg
⁵ Bloomberg Barclays
⁶ Bloomberg

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