Q1 2024 Credit Research Outlook Can We Stick the Landing?
Our view of global cash is relatively sanguine for the near term. G-SIBs continue to display strong business fundamentals. However, cyclical recessions are a risk in most DM economies, especially the eurozone and the UK.
Given the speed and severity of the global rate hiking cycle that began in 2022, there have been doubts about the ability of central banks to engineer “soft landings.” But the absence of large financial imbalances or strains in household balance sheets (and, to a degree, corporate balance sheets) had always suggested that a major recession of the type experienced in 2008 was unlikely. However, given the lagged impact of rate hikes and the less-supportive fiscal policies, we still believe cyclical recessions are a risk in most developed market (DM) economies.
We view the eurozone and the UK as the most at risk of technical recessions in 2024. However, we expect growth to slow materially in all DM economies, so it may be difficult to decipher when a technical recession can occur. Regardless, we expect economic and systemic stress to be relatively mild at the beginning of 2024, given the aforementioned absence of imbalances.
Higher Rates and the Credit Cycle
One primary factor for the economic and credit market resilience has been the large share of consumers and businesses that are locked into low borrowing rates, which has effectively blunted and delayed the impact of rate hikes.
For households in the economies that our investment universe is most focused on, there has been a notable rise in fixed-rate mortgages. Figure 1 demonstrates the material rise in the share of fixed-rate mortgages in the US, the UK, and the eurozone, when comparing the 2003–2007 period to the 2019–2023 period. About 80% of borrowing in the three economies was fixed-rate in the latter period, and this has cushioned households from the impact of rising rates as it pertains to debt-servicing costs.
For corporations, there has also been a growing share of fixed-rate borrowings. An estimated 60% of corporate borrowing in the US is fixed-rate, reflecting a high share of borrowing via bond issuance rather than bank loans. This share is even higher in parts of Europe, with about 80% of corporate borrowing in France and Germany being fixed-rate. This indicates that the full impact of the recent rise in firms’ interest burden will take some time to come through in these economies (source: Oxford Economics, Research Briefing/Global, as of 7 November 2023)
Figure 3: Credit Gap to GDP, 2007 vs. 2023
Available data on interest payments by the private sector in a number of advanced economies supports the view that a shift toward fixed-rate borrowing may have lengthened the transmission lag between changes in interest rates and the impact on the real economy. For example, in the US, interest payments by firms and households have risen by around 1% of gross domestic product (GDP) from their trough, but this has only taken them back to pre-pandemic levels and interest payments are far lower than in 2007 (source: BoA Global Research: US Fixed Income Strategy, 1 November 2023).
While terming out respective debt burdens at low rates has mitigated and/or postponed the risks associated with refinancing debt, it has not eliminated the risk. Weaker economic growth and a higher cost of debt will erode balance sheet quality over time. Even after central banks start easing, interest rates can still end up being substantially higher than when companies funded their liabilities in the past. For instance, in-place high yield (HY) corporate debt coupons are around 6%, while the current yield is around 9%. Given the likelihood of materially higher interest expenses, interest coverage and free cash flow metrics will likely be pressured over time, weighing on credit quality.
Vulnerabilities Persist
There are segments of the credit markets that are particularly vulnerable in a “higher-for-longer” interest rate environment
Consumer Segments
The “cushioning” impact of fixed-rate borrowing will vary quite a lot across economies. The prevalence of fixed-rate borrowing is uneven, and the maturity of fixed rates also varies. While the UK has around 80% of mortgages on fixed rates, the average maturity of these is quite short, so that a substantial amount will need to be refinanced over the next two to three years. This is also true in Canada and Australia. We will likely see the negative impact on interest-sensitive spending come through more quickly in the economies with less fixed-rate debt and shorter average fixed-rate maturities over the coming quarters (source: Oxford Economics, Research Briefing/Global, as of 7 November 2023).
Further, debt service ratios are hovering near record highs for Canadian and Australian consumers, which diverges from the situation in other DM economies. While most key DM households have undergone a substantial deleveraging process following the Global Financial Crisis (GFC), Canadian and Australian households have not followed suit.
Commercial Real Estate (CRE)
Five- and ten-year bullet maturities for CRE debt force refinancing; thus higher rates are a more immediate challenge for the sector. Higher interest rates immediately lower debt service coverage ratios, which leads to lower commercial real estate valuations. This process is still in its early stages, and we expect material credit degradation to continue for multiple years.
High Yield (HY), Leveraged Loan, Private Credit Markets
Corporations are facing a rates backdrop that will continue to put pressure on interest coverage ratios and liquidity, especially for non-investment grade issuers.
Approximately one-third of US HY debt is scheduled to mature over the next three years. HY issuer interest expenses are projected to increase by ~30% if interest rates stay at their current levels for the next two years. Such a scenario would materially weaken profit margins, increase net leverage, and could lead to HY default rates of 8%–10% (from the current ~3.25%) by the end of 2025, when a larger maturity wall of debt comes due (source: BoA Global Research: US Fixed Income Strategy, 1 November 2023).
Credit degradation susceptibility continues to be high within the leveraged loan market. On average, leveraged loan coupons have increased from 4.5% to 9%, interest coverage ratios have decreased materially, and 20% of the outstanding loan index has been hit with downgrades (source: BoA Global Research: US Fixed Income Strategy, 1 November 2023). One risk mitigant is that the pace of coupon increases for fixed rate instruments and thus associated downgrade/default risk should be somewhat measured given that only 10%–15% of that market is up for refinancing annually.
Private debt will face significant challenges as capital costs for non-banks has jumped, causing fundraising and deal flow to slow. The private debt maturity profile is also relatively more aggressive versus other more leveraged parts of the credit markets. According to segment data, private debt has >10% of its deals due in 2024 and another 20% in 2025, whereas HY market maturities do not get particularly heavy until H2 2025. This means some potential problematic situations are likely to surface in the near term (source: BoA Global Research: US Fixed Income Strategy, as of 1 November 2023).
Global Cash Still in a Good Spot
Considering the global cash investment universe, we have a relatively sanguine view for the near term. We prefer debt issued by large global banks and financial institutions, which have limited direct exposure to these particular risk areas. Indeed, the credit expansion cycles since the GFC have differed from that of pre-GFC in that the most highly regulated banks and financial institutions (i.e., systemically important) were materially restricted from lending to the more leveraged types of borrowers—the types of which were outlined as “risk factors” above.
Instead leveraged borrowers, high-yield-rated corporates, and commercial real estate financing entities have gotten a higher portion of their funding from shadow lending agents (private equity and loans, venture capital), capital markets and, in the case of commercia real estate, smaller regional banks. Regulations have incentivized large banks to shift their lending mix to higher-quality borrowers.
After the GFC, the Bank for International Settlements in Basel undertook a thorough statistical review of the indicators of future severe financial system events. It found that the “credit-to-GDP gap” was the single most robust indicator. In comparing the credit-to-GDP gap in DM economies in 2007 to that in 2023 (Figure 3), you notice a clear contrast, and an indication that there is less credit risk in the system during the current cycle. This bodes well for the resilience of asset quality on banks’ balance sheets as economies weaken.
Figure 3: Credit Gap to GDP, 2007 vs. 2023
Global Systemically Important Banks (G-SIBs) continue to display strong and stable financial and business fundamentals. This is partly due to the effectiveness of the supervisory regime and practices pursued since the GFC. With capital levels at, or near, record highs, banks look to be in a strong position to absorb losses on their respective balance sheets, even in the most challenged asset classes, such as commercial real estate. We feel confident in this regard, even as a higher-for-longer environment is a threat to bank earnings given its impact on loan growth, margins and credit performance. Even for the more leveraged consumer economies in our investment universe—Canada and Australia—their respective banks have high portfolio quality and strong underwriting standards, making significant balance sheet write-downs unlikely, in our view.
In Closing
For sure, there is a bit of a “race against time” for certain segments of the credit market, for which funding has tightened considerably over the last couple of years as rates rose. Can funding conditions loosen, and can rates fall quickly enough, to avoid a lasting financing disruption for CRE, private debt, HY corporates and the weakest consumers?
If lending remains tight in those particular segments, what will the spillover into the broader economies be? At a minimum, we would expect corporate profit margin compression, cautious business confidence, and further slowing in capital expenditure and hiring. As such, there is risk that a negative feedback loop between business caution and moderating household income growth will raise recession vulnerability.
While a “soft landing” for global economies and credit markets in 2024 is certainly a reasonable expectation, we prefer select cash investment counterparties that are best equipped to maintain their fundamental credit profiles through a variety of macroeconomic scenarios, including a higher-for-longer interest-rate environment and tighter financial conditions.