Here are the big dangers looming in the credit market

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Inflation and the effects of higher interest rates are among the risks that investors and analysts described. But also an energy crisis, geopolitics, and ‘the…

We focus on cash flow, so the biggest risk we are watching is the impact of inflation and potential economic weakness on issuer cash generation. In these more volatile markets, seniority, borrower scale and sector selection become increasingly important.Article contentThe market has gotten incredibly comfortable with central-bank support, which has ranged from being an active buyer in the primary and secondary markets to buying high-yield assets during COVID-19.

This gets me to the longer-term concern: the moral hazard created by a Fed deeply entrenched in repeated market support. Think of Minsky’s “stability is destabilizing,” meaning that the feeling of stability and safety encourages people to take more risks than they would have otherwise. That risk-taking, because it is by its nature cavalier and oblivious to risks, breeds financial instability and even crisis.

We have seen disproportionate growth in bank loans and private credit over the past several years, somewhat at the expense of high yield. Any problems — such as elevated credit losses — in those markets due to more aggressive financial leverage or weaker covenant structures could have knock-on impacts for high yield.

Corporate fundamentals in both IG and high yield remain strong, so do not expect severe credit deterioration. Pockets of good opportunities are arising.Current valuations are dismissing the impact of a potential full-blown energy crisis. The fundamental picture for credit remains robust, default rates are expected to stay low, and company earnings have thus far proved resilient. However, company earnings guidance has been revised lower looking forward.

A lot of people bought credits with looser and looser lender protections and thought it didn’t matter because the companies would be fine. The economic backdrop was so strong. Now the tide has turned and all this debt is sitting out there. When people realize they could really lose money on these positions, you could see capital flows out of credit that create a self-fulfilling prophecy.

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