Corporate credit outlook

Q1 2022 Corporate credit outlook

The solid backdrop for credit sets the scene for compelling returns. It will be a credit-picker’s market, and we look to high yield bonds and senior secured loans as areas of continued opportunity.

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January 19, 2022 | 24 minute read

Corporate credit markets finished 2021 with solid returns as high yield bonds and senior secured loans returned 5.4% and 5.2%, respectively. Despite numerous challenges—a persistent pandemic, rising inflation, rising short-term interest rates, investor outflows in high yield, a transition away from LIBOR—high yield and loans posted only two months of negative returns on the year. Support from an exceedingly strong equity market in the U.S., policy accommodation from the Fed for much of the year and government fiscal stimulus early in 2021 set the stage for the positive, generally stable environment. But perhaps most important, we believe the confluence of favorable conditions created extremely strong underlying credit fundamentals. Credit issuers generated record earnings growth in the second quarter, and by the end of the year, default rates had fallen to a record low for high yield and a 10-year low for loans. With economic growth expected to remain strong in 2022, this underlying support establishes the base for our expectation for compelling albeit income-based returns in 2022.

Key takeaways

  • Corporate credit markets finished 2021 with solid returns as high yield bonds and senior secured loans returned 5.4% and 5.2%, respectively.
  • A supportive backdrop led to extremely strong credit fundamentals, with robust EBITDA and revenue growth and plummeting default rates in both high yield and loans. Though markets broadly face new challenges in the year ahead, we believe these strong fundamentals will provide a ballast against potential headwinds.
  • With spreads near post-Global Financial Crisis tights, we forecast a predominantly income-driven return in 2022.

Similar to 2021, credit markets are faced with both new and lingering challenges for 2022. Omicron has driven new COVID infections to their highest on record while inflation, as measured by the CPI, rose to the highest level since 1982. Considering tight credit spreads at year-end, credit markets have less ability to absorb a risk-off sentiment or, for high yield specifically, higher rates from a hawkish pivot by the Fed. It is this latter point that we think has the potential to allow loans to outperform bonds in 2022. While we have written before that high yield tends to perform well in periods of rising rates, and we think that will continue to be the case, the floating rate nature of loans provides additional protection and benefits from favorable investor sentiment for floating rate product if rates continue to rise. Compared to other, higher-rated and more duration-sensitive fixed-income asset classes, we expect high yield and loans to outperform.

We are watching a number of factors in 2022 as highlighted in the next section. Inflation is a hot topic and poses both direct and indirect challenges to credit. We are also watching how the Fed reacts to this new inflationary environment. The favorable economic backdrop that typically coincides with Fed rate increases has historically supported credit markets, but uncertainty and transition from a more accommodative monetary policy will likely bring interim periods of volatility. Last, while the tight spread environment for the broad markets will likely limit price appreciation, we believe value still remains outside of traditional credit benchmarks. Collateralized loan obligations (CLOs) are one area that we think represents a unique opportunity for investors.

Even though markets will be faced with new challenges in the year ahead, we believe strong underlying fundamentals in credit will provide a ballast against these potential headwinds. Tight spreads may limit capital appreciation potential for benchmark-constrained investors, but the income generated by high yield bond and loan markets is still compelling compared to other fixed-income markets. For investors that can look beyond these traditional benchmarks, we believe additional possibilities exist to generate attractive total returns.

This information is educational in nature and does not constitute a financial promotion, investment advice or an inducement or incitement to participate in any product, offering or investment. FS Investments is not adopting, making a recommendation for or endorsing any investment strategy or particular security. All views, opinions and positions expressed herein are that of the author and do not necessarily reflect the views, opinions or positions of FS Investments. All opinions are subject to change without notice, and you should always obtain current information and perform due diligence before participating in any investment. FS Investments does not provide legal or tax advice and the information herein should not be considered legal or tax advice. Tax laws and regulations are complex and subject to change, which can materially impact any investment result. FS Investments cannot guarantee that the information herein is accurate, complete, or timely. FS Investments makes no warranties with regard to such information or results obtained by its use, and disclaims any liability arising out of your use of, or any tax position taken in reliance on, such information.

Any projections, forecasts and estimates contained herein are based upon certain assumptions that the author considers reasonable. Projections are necessarily speculative in nature, and it can be expected that some or all of the assumptions underlying the projections will not materialize or will vary significantly from actual results. The inclusion of projections herein should not be regarded as a representation or guarantee regarding the reliability, accuracy or completeness of the information contained herein, and neither FS Investments nor the author are under any obligation to update or keep current such information.

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Kara O’Halloran, CFA

Director, Investment Research

Robert Hoffman, CFA

Managing Director, Investment Research

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