Narrow spreads and elevated risks make for tough credit market conditions

Sajjaad Ahmed, Credit Analyst at Prescient Investment Management

Credit market conditions continue to be characterised by elevated risk levels, yet yields for these risk levels remain suppressed. The general state of the Debt Capital Market (DCM) is one of a limited supply of assets, with significant excess demand from investors.

Although risks are considered to be at elevated levels, spread compression continues. This is most likely due to the supply-demand imbalance that’s currently at play in the market, and not fundamental in nature. As a result, we generally view credit pricing as expensive. There are however opportunities that show value, and in which we’ll participate.

Muted economic conditions led to credit issuances dropping from pre-Covid-19 levels, with fewer borrowers coming to market to finance expansionary activities and issue debt. SOE activity in the primary market remains muted, given negative market sentiment towards this sector, with the unresolved Land Bank default still at play. However, green shoots are emerging – in terms of recent public issuances as well as an improvement in secondary trading activity in the credit market across sectors.

Debt issuance by “known names”, namely better-rated counterparties, continues to be well supported in DCM auctions. Bid-cover ratios are coming in at 2 to 3 times, the strongest they’ve been in four years. Auction prices are also clearing at the lower end of guidance, if not below, resulting in the compressed spreads that currently prevail in the credit market.

Another sign of the tough credit market conditions is the number of borrowers raising capital via private placements instead of through public auctions. Private placements have generally been a source of funding for lesser-known issuers or issuers with weaker credit ratings, or they’ve been used in uncertain times – as was seen during the turbulence of 2020.

Given this view of suppressed yields and tough credit conditions, we continue to rely heavily on our process, which is one of the key pillars of our systematic approach to investing. Prescient believes in the importance of process and as a result, we constantly strive, via our research efforts, to ensure that ours is robust and consistently applied – irrespective of what external markets may be doing.

When considering credit and credit positioning, we start with a top-down approach, assessing the credit environment by considering various economic variables. By quantitatively modelling these factors, we arrive at a Prescient Credit Cycle Indicator, which relies on the Dynamic Factor Models proposed by Stock and Watson. Our Credit Cycle Indicator ultimately infers how we should be thematically positioned, and this quantitative approach is supported by sound fundamental analysis. When working together, it enables us to appropriately measure corporate credit risk across sectors, and to thereby identify appropriate investment opportunities for our wide range of funds.

The current credit theme, as determined by a combination of the output of our Credit Cycle Indicator, our consideration of individual counterparty default probabilities, and finally, the yields offered on these opportunities, is one of “elevated risk levels with suppressed yields”.

Based on this theme, we continue to be very selective in what we buy. We’re currently investing in what we consider defensive sectors or assets with defensive characteristics (i.e., assets with a lower probability of default), with a further preference for secured offerings (i.e., assets that reduce the potential loss given default). Furthermore, we have a short- to medium-term bias and continue to be cognisant of credit spread duration.

From a sectoral perspective, we remain bullish on banks, insurers, as well as “defensive” corporates. We remain neutral on cyclicals and neutral on the SOE sector as a whole. We have a cautious view of the manufacturing, property, construction, travel and hospitability sectors, while noting certain pockets of recovery within these.

In summary, it’s important to note that, despite our sectoral preferences, our credit philosophy is premised on delivering consistent outperformance for our investors via our Quantimental Approach. We are firm believers in systematic investing – an approach that is rational, rules-based, data-driven, and backed by clear processes.