Insight  |  January 3, 2023

Muzinich & Co. 2023 Outlook - Income is Back

Given significant moves in 2022, we believe credit markets offer attractive carry, and we expect the excess return outlook to be positive in 2023.

Key Takeaways

• Focus on Credit Quality - Given the heightened recessionary risks, we advocate a focus on higher quality credits within the BBB and BB ratings segments.
• Valuations Offer a Good Entry Point - Following a significant sell off in 2022, credit market valuations, compared with historic and forward-looking equity returns, have returned to attractive and competitive levels - notably in Euro-denominated bonds.
• Default Rates are Overdone - While defaults are likely to increase, we do not believe they will reach previous bear market highs or those implied by the market.
• End in Sight for Interest Rate Rises - Central banks may be nearing the end of their interest rate hiking cycles, even if their final targets remain unclear.

High Quality Credit a Prudent Choice

Ahead of what is likely to be a period of economic weakness, investing in quality credit offers compelling risk/reward characteristics and appears to be a prudent investment within both investment grade and high yield. The large foreign exchange hedge premium adds to the attractiveness of euro-denominated markets. Within emerging markets, we expect investors will be rewarded by the extra spread premium versus equivalent quality US credit. Within high yield, we are focusing on the higher quality segments of BB and strong B rated credits. In Europe, we believe hybrids bonds and financial subordinated debt appear good value, as their issuers tend to be investment grade rated with little default risk. Leveraged loans also offer comfortable carry, although again we would advocate a focus on higher quality credits, with a slight overweight to US dollar denominated markets.

A Flexible Approach to Sector Allocation

Given the uncertain macroeconomic backdrop and growing recessionary risks, we maintain a preference for defensive sectors such as telecommunications and healthcare. We take a more selective approach to cyclicals, investing in credits that offer value, cash flow and a capacity for balance sheet improvement should the economic situation deteriorate. We prefer to avoid sectors linked to discretionary consumption or real estate, although the latter may soon offer selective opportunities as balance sheet repair becomes a priority.

Stay at the Short End 

Currently we believe short duration strategies appear compelling given they offer less volatility, access to attractive credit market valuations and higher total yield. There will come a time to go longer duration, but we would like to see more convincing signs of a deceleration in global inflation before we change the risk mix between credit and duration. Tactical strategies may adopt a barbell strategy regarding duration to capture the value of long investment grade.

Credit markets are finally offering a carry that disappeared for many years and we expect the excess return outlook to be positive in 2023. Income is back and investors should enjoy it.

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