source: Bloomberg

In January this year, interest rates dropped at the middle and longer end of the curve. This was due to the expectation that central banks would tighten monetary policy less than expected moving forward due to the decline in headline inflation figures, despite the conviction from both Powell (Chair of the US Fed) and Lagarde (President of the ECB) to continue raising rates to fight inflation. As a result, equities rallied and so too did other asset classes, including credits. The consensus now is that a milder recession and a softer landing has been priced into markets, with the ECB expected to begin cutting rates in H2 2023.

ECB Rate hike expectations

Graph 2: implied ECB interest rate hike expectations



source: Bloomberg

While we expect more rate hikes to come from the Fed, ECB, BoE, and other central banks, we believe this is adequately priced in the Euro market. We do expect to have periods where we will see upside pressure on 10-year rates, but not to the same extent as we saw last year. Yields on both HY and IG indices, as displayed in graph 3, have risen to historically-attractive levels, providing a cushion against an increase in rates and credit spreads in our view.

Graph 3: Yield on ICE BofA indices



source: Bloomberg

Attractive entry point for Euro Investment Grade Credit:
2023 started in the Goldilock scenario with a strong start to the year for credit, however we do envision 2023 another volatile year for bond markets. This is simply due to the multiple drivers of returns. We expect to see periods of strength driven by technicals, strong fundamentals, perception changes with respect to the economic slowdown, and central banks reaction to the path of inflation. 

The current yield on investment grade credits looks attractive from a historical perspective. Nevertheless, the ability to offset a further rise in interest rates and credit spreads will be key for total return expectations for 2023 for the asset class.

Base case scenario:
Our expectations for the remainder of 2023 is guided by our base case scenario, which we believe has a 50% probability of playing out. In this scenario, we expect core inflation will remain sticky for the next 12-18 months, forcing central banks to continue tightening in order to bring inflation down to target levels. Combined with ongoing supply chain issues, this will result in a moderate recession globally, and will impact the earnings power of corporates. Furthermore, rising wages and elevated input costs will additionally impact margins. Additionally, the current unstable geopolitical situation will continue the trend of risk aversion and volatility.

In this scenario, credit spreads will remain volatile and could have room to widen by 50-75 bps from current levels. Nonetheless, we will also see periods where there are sharp reversals and tighter spreads.

Wider credit spreads in combination with rising interest rates will impact total returns. However, we believe higher yields across the board, combined with a moderate duration, should provide a cushion. Total return expectations in this scenario are still positive and credit is likely to outperform government bonds.

In this scenario the differences in spread levels between companies will increase and overall spread levels will be volatile. This will provide ample opportunities to add alpha, with an active investment style offering opportunities from both a directional and relative-value perspective.

In the alternative, Bear case scenario (25%) we expect:
In this scenario, we assess the impacts of central banks implementing easing policies too soon. As a result of this action, inflation remains high for many years, possibly leading to stagflation where a long recession combined with high inflation erodes public trust. Political defragmentation gathers pace and leads to more social unrest. The geopolitical situation remains uncertain and unstable (Ukraine, China, others). The housing market is impacted by higher mortgage rates and declining real disposable income. Default rates start to rise rapidly from low levels.

The impact would be that credit may well widen 120-150bps from current levels. Company-specific, idiosyncratic risk increases and will be especially visible in the tails of the credit universe. Rates would likely decline initially from current levels, but rise sharpy again to deal with the persistently high inflation. The combination of these two factors in our view would result in negative total returns.

In a bear market such as the one described, it is important to avoid over-levered, high-risk names, which have the potential for negative rating migration or even default. Our top-down framework would guide the portfolio to a more directional underweight, whilst the bottom-up element of the process would help us avoid deteriorating individual credits.

In the alternative, ”Goldilocks” scenario (25%) we expect:
In this scenario, we assess a situation where core inflation drops close to target levels set by central banks. This will be driven by falling of commodity prices and the improvement of supply chains to their pre-pandemic levels. The result would be a soft landing whereby a recession can be avoided and earnings growth remains at healthy levels. As a result, corporate fundamentals will remain resilient and defaults will stay at a historically-low level. Quantitative Tightening will not distort markets, and currently attractive yields will attract more inflows into credits. In this case, credit spreads have room to tighten another 20-25 bps. In such a supportive market environment, interest rate levels will decline from current levels and credit spreads have room to compress further to their historic tightness. This will result in a positive total return.

In such a scenario, we will focus on relative value, sector themes, and a directional top-down positioning. We will actively manage the relative value opportunities arising and seek to position the overall portfolio risk profile to benefit from the tightening in credit spreads.

Our approach and conclusion:
Based on our central scenario we expect a volatile year for credits – providing both top-down as well as bottom-up opportunities to add alpha to the portfolio. Our approach combines a top-down market view with bottom-up fundamental credit analysis and security selection, which we believe will allow us to benefit from this market environment. We focus on identifying opportunities and avoiding deteriorating credits, something which our philosophy has historically allowed us to do throughout the years and has resulted in a sustained long-term performance track record of generating alpha – both in up markets and down markets (graph 4).

When investing in credit, downside protection is essential. The ability to actively position the portfolio to different scenarios is a key differentiator versus a passive strategy, be it via issuer selection, capturing relative value, or adjusting the overall risk profile of the portfolio with a more directional view.

Graph 4: Gross Investment return Kempen Euro Credit Strategy (base 100 in April 2008)



source: VLK IM and Bloomberg