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Chapter Three: Credit

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Craig Bergstrom, Chief Investment Officer, Corbin Capital

We enter 2022 with credit spreads at near all-time tights, inflation at multi-decade highs, central bank policies rapidly changing from extreme easing to potential tightening measures, and COVID variants still rapidly spreading. Considering this backdrop coupled with a less accommodative policy on the horizon, how is an investor supposed to make their target returns should we experience even minor hiccups?

Corbin continues to believe that the key to generating returns in this environment is the combination of active management and sourcing off-the-run investment opportunities. We think allocations to traditional credit are more likely to generate lacklustre returns, creating meaningful opportunity costs for pension investors. In these uncertain times, we are therefore keenly focused on less-trafficked areas of credit markets, building portfolios of off-the-run assets with the potential to generate consistent returns. In traded markets, this means focusing more on special situations, such as event-driven opportunities and pockets of structured credit that still trade wide to high yield or other comparable risks.

We also see many investors moving substantial allocations from liquid credit to illiquid private credit, which offers higher return potential with less mark-to-market volatility, though the sponsor backed lending market seems very competitive to us. That said, we think there are meaningful return premiums for non-sponsor corporate borrowers, but currently think the best risk adjusted return opportunities can be sourced in areas of specialty finance, such as land-banking and non-QM mortgage origination. We believe that investors who make the leap from liquid to private credit and from sponsor-backed lending to more niche private credit strategies will benefit from positioning their portfolios for enhanced returns that will compound for years to come.

While 2021 was a year of economic recovery, which buoyed risk assets, we expect 2022 to require a nimbler approach.

Pavel Mamai, Co-Founder and Managing Partner, Promeritum Investment Management

In terms of market outlook for 2022, we can only comment on emerging market credit markets. We believe EM investment grade will trade in line with core rates, while the spreads in EM high yield widened significantly in 2021 to provide better protection against a core rates sell-off. New issuance in high yield will be more limited versus last year, but it is difficult to see significant inflows into the asset class in the inflation/ Fed tightening environment. When and if core rates stabilise though, the outlook for EM credit will be much brighter.

With regards to our investment strategy and area of focus within credit, in terms of opportunity and risk, our view remains similar to last year: macro factors – inflation, core rates, Covid-19 – are the biggest risk factors for EM credit. We believe, however, that events and volatility within the asset class provide for good alpha-generation potential. In H1, we will focus on turn-around in Tunisia, restructuring in Zambia, and potential de-escalation in Ukraine/ Russia. We will also be paying significant attention to Turkey and CEE rates markets.

Philip Crate, Portfolio Manager, Altana Corporate Bond Fund, Altana Wealth

2022 is going to be a tricky year for credit investors. Inflation concerns will pressure central banks into withdrawing their asset purchase programmes and to start hiking interest rates, which will put upward pressure on government bond yields. We expect the Fed to undertake a faster pace of taper, which will give them greater optionality for an earlier liftoff in rates, and two, if not three, rate hikes. We also expect the Bank of England to raise interest rates, while the ECB is likely to remain on hold. A supportive and continuing accommodative ECB versus a more hawkish Fed is one main reason why we prefer EUR over USD credit entering 2022.

A rising yield environment will likely result in negative total returns for investment grade credit across the major currencies, although high yield is expected to eke out a positive return (+2 per cent – 3 per cent), given higher carry and another year of low credit losses, as 2022 is expected to be a benign year for defaults.

The rapid spread of new Covid-19 variant Omicron could negatively affect credit performance in the early part of 2022 by triggering further restrictions across economies, with negative implications for travel and consumer discretionary sectors. We would view any sell- off among the better capitalised players in these sectors as a buy opportunity. Putting these specific sectors to one side, we do not anticipate that the new variant will trigger any drawdown of a similar magnitude to March 2020.

Overall, we expect credit risk premiums to finish 2022 broadly where they started. But they will face periods of volatility as credit spreads widen on concerns about the inflation outlook and central bank responses, as well as new Covid-19 headlines. At some point, dip buyers will be attracted, and the widening will be reversed ahead of the next headline. We also expect dispersion for sector performance to increase, and this will provide opportunities for the better credit funds to outperform.

Given our opportunistic and flexible trading strategy which focuses on short duration event-driven credit, our fund is well- positioned to outperform again. Short duration high yielding credit will be the sweet spot for investors in 2022, particularly given the market expectations for higher government bond yields across developed markets.

Amine Nedjai, CEO, Alpha Blue Ocean

With the labour market healing and inflation increasing, the Fed is taking on a more hawkish stance, which is causing the short end of the yield curve to increase rapidly and, in return, credit spreads have increased as well. The Fed will be less accommodative, which will cause credit spreads to rise further as investors demand higher premiums, especially at record high duration levels, meaning the market is very sensitive to interest rate increases.

What is particularly worrying is the amount of leverage raised over the past years and, while large profitable companies have been able to strategically raise debt to shore up their balance sheets, a lot of companies will have to tap into the market in 2022 to refinance their debt, and the medium- and small-sized firms may find themselves in a very difficult situation as investors ask for higher premiums. Given our focus is hybrid debt, we view this as an opportunity whereby many companies will be able to benefit from our alternative financing model.

At ABO, we provide flexible hybrid financing solutions which can be viewed as mezzanine type debt that does not require cash redemption. This approach provides companies with the flexibility to redeem in either cash or shares, depending on what is most suitable for them at a particular time. As markets become even more volatile, issuers will want to secure funding for the next few years using our products in the knowledge that we are committed to financing them no matter the market conditions. The main risk will be the drop in stock market liquidity, especially in the small-caps segment, which exacerbates volatility further and requires greater fine-tuning to our structured products. As for sectors, we believe oil and gas could be interesting given the level of underinvestment and the number of recent bankruptcies over the past years which has caused drilling in US to drop significantly. We expect demand for oil to continue to rise, which could lead to a busy year from a capital markets perspective.

Furthermore, we continue to focus on healthcare, and we expect this sector to continue to do well. As the sector continuously innovates, it will attract capital flows, especially in nascent parts, such as longevity, and the supply of companies coming into this space will be competing heavily for this capital which presents a great opportunity for us.

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