Negative credit migration calls for caution

A lot of attention has rightly been focused on the recent volatility in the banking sector but corporate credit continues to perform well and some interesting rating action caught our attention last week. German auto-part manufacturer, Schaeffler, was upgraded back to Baa3 by Moody’s, after having suffered a downgrade to the high yield category in June 2020, after being watch listed at the onset of the pandemic in March 2020. 

The case of Schaeffler is credit specific however we think it should be considered in a broader analysis of ratings migration for the previous quarter. Although a somewhat lagging indicator, ratings migration is used to provide an insight into the fundamental trends of issuers following the release of financial statements. 
 
For North America, in Q1 the Moody’s ratio of corporate upgrades to downgrades was 0.74; indicative of credit deterioration, but improving from a ratio of 0.53 for the last quarter of 2022. While in Western Europe, the observation is very similar whereby this ratio was at 0.66 for Q1 this year and a small decline from 0.80 for the last quarter of last year. However this credit deterioration was not unexpected. The tightening of financial conditions induced by the central banks, along with a continued slowdown in economic growth is naturally making the fundamental backdrop for corporate issuers more challenging, and indeed, when looking exclusively at high yield issuers, the ratio of upgrades to downgrades deteriorates further in both regions.
 
Looking ahead, we expect most issuers to have a conservative outlook given the ongoing economic uncertainty. Schaeffler, in its last earning calls relating to its full year 2022 results, was a good example of this commenting on a ”choppy environment” and toning-down statements relating to their 2023 outlook. 
 
In 2022, a healthy consumer was a key driver that helped issuers navigate a deteriorating environment, and the direction of the unemployment rate will likely be important for the fundamentals of issuers this year as well. For now, the Federal Reserve expects the unemployment rate to reach 4.5% by the end of the year; a steep increase from the current level of 3.6% but well inside the longer term average. While in Europe, the ECB expects a stable unemployment rate for 2023. 

An increase of the unemployment rate at a faster pace than central banks are currently expecting would obviously pose a challenge to corporate issuers and would likely translate to a higher default rate and higher credit spread. Against this backdrop the current spread for the US HY index, of 475bps, is only slightly above the 10yr average, whereas in Europe, the HY index has a spread of 490ps which is approx. 90bps above the 10yr average; the yields available across both are, however, well above the 10yr averages thanks to higher rates. 

In our view both indices still offer value opportunities, but investors will need to be selective and disciplined, particularly given both the prospect for further negative rating migration and the uncertain outlook generated by the aggressive central bank rate hikes.