How credit investors are navigating rate cuts and geopolitical volatility

26 March 2024

The following was produced and published by Livewire on 26 March 2024.

Confidence is back – but volatility isn’t going anyway for investors. Ares’ Samantha Milner shares her views on how Ares is investing.

Confidence has returned to markets as the signs of a soft landing seem clear. We may have seen falling profits in the recent February reporting season, mixed credit market performance, and continuing volatility in commodity prices, but overall, investors have some certainty in the macro-economic environment again.

Following equity markets, credit markets rallied strongly late last year. Heading into this year, floating-rate assets have tended to outperform fixed-rate peers. Investors expecting rate cuts later this year are locking in yield.

Of course, the prospect of US rate cuts isn’t the only activity in play for 2024. This is also a year for federal elections, with the US and India among the most significant and the continuation of conflicts in Ukraine and the Israel-Gaza region. All of these developments will weigh on markets.

In this interview, Samantha Milner, Partner and Portfolio Manager in Ares Global Liquid Credit Group, discusses the macro-outlook and how Ares is investing across credit markets to account for risks and opportunities.

Weighing up the prospects of a soft landing in the US

To say markets now simply expect a soft landing, have priced rate cuts in and have moved on to buying is stating the obvious – but is there merit behind this consensus view?

Milner says the data supports this conclusion.

The US fourth quarter GDP increased 3.3% on an annualised basis while payrolls remained robust¹.
Core inflation continues to fall, with three- and sixth-month rates below the US Federal Reserve’s 2% target¹.
The ISM Manufacturing survey is now approaching expansionary territory (it was previously pointed to as a leading indicator for an upcoming recession).¹

The Bloomberg survey of economists also reached a consensus of a soft landing¹.

There is a strong likelihood of a rate cut in 2024.

Key themes across markets

Milner points out that volatility is elevated – even as we are tipping a soft landing.

“We continue to closely monitor potential headwinds including the 2024 elections and the potential impacts of elevated geopolitical tensions. Importantly, we remain focused on security selection,” she says.

She anticipates slower global economic growth throughout 2024 and notes that the year-over-year growth of revenues and EBITDA continues to slow for S&P 500 companies.

“We expect interest coverage ratios and profit margins to slowly erode in the quarters ahead given the lagged impact of higher policy rates.

Given the potential for a ‘higher for longer’ scenario, we continue to actively screen our portfolios for names with weak forecasted interest coverage ratios where trading levels are not compensating for the risk,” Milner says.

She is also seeing an increase in capital market activity, with January 2024 seeing the heaviest refinancing activity for bonds since May 2021, and expects more M&A activity across the year². This all means the potential for capital appreciation in bonds this year, though Milner expects income to remain the primary driver of returns.

An interesting trend that Milner has started to see relates to recoveries and weaker loan structures. This ties in with data from S&P Global, which found loan recoveries were down to 65.2% in 2022-Sept 2023, compared to a long-term average of 73%.

“Given looser documentation, fewer maintenance covenants and more loan-only capital structures, we expect recoveries in 2024 to be lower than their 25-year average,” she says.

Again, this points to the importance of credit selection to avoid defaults and when you have a default, being exposed to credits with stronger recovery potential.

Away from these themes, Milner also believes investors should be aware of how the market has changed in more recent years and be ready to tackle it in how they invest.

“Since the ‘great financial crisis, structural changes in capital markets have led to shorter and swifter dislocations.

As a result, diversification and active allocation are essential to capturing the best relative value opportunities that arise in episodic periods of volatility,” she says³.

Investing in volatile markets

Credit selection is critical in periods of volatility and 2024 is no exception. Milner believes there are opportunities to be found across the credit landscape.

It’s important to highlight that Ares specifically targets investments in a $6.1 trillion⁴ space it describes as the “sweet spot of credit”. This includes European high-yield bonds and bank loans, US high-yield bonds and bank loans, and investment-grade collateralised loan obligations (CLO) debt securities.

“With attractive cash yields in the high single digits, loans are providing an attractive forward return opportunity. Currently, we view Single-B-rated loans as offering the best relative value.

At discounted levels, high-yield bonds offer convexity and an attractive alpha-generating opportunity,” says Milner.

CLO debt tranches are also benefitting from the market environment and Ares sees significant value in this space. These assets are a portfolio of bank loans subject to certain guidelines, such as industry concentrations, rating limitations, maturities and yields. Ares focuses on A and BBB-rated tranches of CLO debt securities and believes that poor market understanding of the asset class has created pricing inefficiencies in this space. For example, BBB-rated CLO debt securities are currently offering a 400bps premium compared to similarly rated corporate bonds⁵.

Managing sector allocations

In the current environment, Ares is “underweight sectors that are more susceptible to consumer discretionary income weakness, input cost pressures and general cyclicality.” Liquidity is also a key consideration.

Their multi-asset credit portfolios are more overweight defensive sectors, while also using those sectors “more upstream in supply chains and companies with strong pricing power, including software and necessary services sectors.” Think of the more essential sides of technology – particularly enterprise software – rather than the more cyclical sides.

The larger allocations in the Ares portfolio are Information Technology, Healthcare and Financials, though Ares is underweight compared to the blended 50% high yield bond/50% bank loan index.⁶

A final consideration for investors

“Credit is a diverse asset class – so when we hear ‘spreads are tight in credit’, the question we always ask ourselves is what part of the $6.1 trillion credit market is this in reference to?

We believe relative value opportunities are present within the tradable corporate and alternative credit universe through a variety of market environments,” says Milner.

Taking an active and flexible approach to credit is critical in volatile markets, and Ares believes that a multi-asset approach can add significant value and diversification.

Footnotes:

As of 29 February 2023. Source: Bloomberg
Source: JP Morgan. As of 31 January 2024
Diversification does not assure profit or protect against market loss. All investments involve risk, including possible loss of principal
Source: Global Credit Suisse Leveraged Loan Index, ICE BofA Global High Yield Index, J.P. Morgan CMBS Research, J.P. Morgan ABS Research: ABS Volume Datasheet Report, Ares INsight database, Intex. As of 31 December 2023. Assumes a 1.11 EUR/USD exchange rate where applicable.
As of 31 December 2023. Assumes SOFR of 5.33%. Source: J.P. Morgan CLOIE. Source: Bloomberg.
As of 29 February 2024. Bank loans reflected by the Credit Suisse Institutional Leveraged Loan Index (“CSLLI”) and high yield bonds reflected by the The BofA US High Yield Master II Constrained Index (“HUC0”).

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