Anne Greenwood, Institutional Portfolio Manager on the BlueBay U.S. Fixed Income team, explains that despite recent market turbulence, we expect the economy to continue its upward trajectory, with active managers poised to capitalize on volatility.
Watch time: {{ formattedDuration }}
View transcript
Good afternoon and welcome back to The Weekly Fix. My name is Anne Greenwood, Institutional Portfolio Manager here with the BlueBay Fixed Income team at RBC. It is late October, and the chill has started to settle in here in the northeast. The market, on the other hand, is still carrying some summer heat as equities continue to break record highs and credit spreads sit near record tights. With Halloween just around the corner, investors continue to be wary of anything that might spook the market in the days and weeks to come. While we don’t disagree that we are in a fragile market environment across all vectors, we do believe the music can continue to play on - at least over the near to medium term horizon.
Recent headlines have certainly awoken market jitters in the past few weeks as a handful of idiosyncratic events put it on edge. Starting with Tricolor to the latest concerns around some of the regional banks CRE (Commercial Real Estate) exposure just last week, risks do seem to be bubbling up. So far, however, what we have seen does not raise concerns of a systemic problem but does warrant heightened scrutiny by investors.
In some cases, markets re-pricing this risk has presented an opportunity to add to fundamentally stable companies at a better entry point.
Critical still, is bottom-up security selection as we do expect to see increased volatility ahead.
Looking at some of the more top of mind items that could create further tensions in the market, we continue to keep a close eye on the lower quality high yield and leverage loan market as well as private credit, namely BDCs (Business Development Companies). Macro concerns around tariffs, political uncertainty, and a continued government shutdown could also pose challenges to the investment landscape.
In lower quality high yield, specifically CCC rated and below, we are starting to see some deterioration in credit metrics, like interest coverage ratios. On the other hand, moving up the market, double and single B credit metrics remain stable to improving, reinforcing our view that broad fundamentals for the US HY (high yield) bond market, as well as for the investment grade market, continue an upward trajectory. With the growing disparity between the haves and have nots, our view remains constructive on high yield overall, but caution is advised when considering that lowest quality cohort.
In leverage loans, we have seen default rates outpace high yield bond default rates over the trailing 12 months, and contrary to what you typically see during rate cutting cycles, we expect this to continue.
Concern around BDCs has also increased in recent weeks and is one we have been highlighting for some time – and now just to clarify, private credit is of course a broad asset class, and what we are more focused on is risks in middle market direct lending and BDC structures rather than the high-grade part of the market which seems generally fine.
One of the main risks or concerns that we see is the growing usage of PIK (Payment-In-Kind) financing in many of these BDC vehicles. This could be a warning signal on the underlying company’s inability to generate revenue and cover interest costs. Furthering this view is that despite strong profits and revenue growth, a large part of the universe is operating with a negative profit margin – suggesting that profits may not, or not yet, be translating into cash available for spending or paying down debt.
And perhaps not last but last for today’s discussion on areas that could spook the market this Halloween, is the government shutdown. Although a government shutdown has plenty of real-world negative implications, we do not believe, at this point, it should be a significant cause for alarm. The reason for this is that historically, critical activities keep going and the economy generally continues to function with limited resulting impact to financial markets. With that said, the longer it continues, the greater the impact it could have and the greater risk there is of surprise or shock events occurring. In normal times, when the margin for error is wide and the range of outcomes is narrow, this would be less of a concern. But with spreads priced nearly to perfection amid growing market instability, a prolonged shutdown could provoke a more material negative reaction.
As a result, in the near term we are keeping these key risks in mind, but do not believe we are in the beginning stages of a more systemic downturn. Longer term, it is too early to say what the impact will be. But, in the meantime, as these issues get worked out, we think this environment can create opportunities for active managers to be liquidity providers at very attractive levels and generate strong risk adjust returns along the way. Thanks for joining us and we’ll speak with you next week.
Key points
Despite recent jitters and fragile conditions, the market is expected to continue its upward trajectory in the near to medium term, with record-high equities and tight credit spreads.
Investors should monitor lower-quality high-yield bonds, leverage loans, and private credit due to deteriorating credit metrics and increased default rates. The government shutdown, while not immediately alarming, could pose risks if prolonged.
Active managers can capitalize on market volatility by providing liquidity and generating strong risk-adjusted returns, particularly in fundamentally stable companies with improved entry points.