Where We See Value in Credit Markets in 2024

• We view the market’s expectations of six to seven Federal Reserve rate cuts in 2024 as overly optimistic, and instead expect a slower pace of around three rate cuts, along with a slowing of the Fed’s balance sheet runoff starting in midyear.

• This macro backdrop should result in slowing but stable credit fundamentals, though valuations largely reflect a favorable outcome, particularly in developed markets.

• While we would not characterize credit valuations as cheap, we see relative opportunities across the credit spectrum, including higher-yielding leveraged loans and CLO debt as well as segments of markets that have lagged the rally, such as emerging market credit.

• While we find slim opportunities for narrowing of credit spreads, yields remain very appealing and offer a fair amount of cushion.

As the first quarter of 2024 unfolds, the economy continues an expansion that has surprised many. Financial markets have rallied significantly and commenced the year with outsized expectations for significant Federal Reserve monetary easing. Given developments thus far, what lies ahead for credit markets in 2024?

Credit spread valuations have reached the low end of what we view as fair value amid slowing but stable fundamentals. While price appreciation potential has largely played out, elevated yields provide attractive return potential, and rising dispersion is resulting in relative value opportunities.

A review of the recent past helps to inform our views of what’s to come. We saw a rate rally in the first three quarters of 2023 after a tough 2022, when Fed rate hikes hit high yield especially hard, while loans and investment grade collateralized loan obligations (CLOs) held up better because of their floating-rate nature, with double-B CLO tranches somewhere in the middle. Despite some volatility last year, even the troubled regional banking sector saw spreads recover by year-end. Nevertheless, in January through September, floating-rate credit substantially outperformed fixed-rate credit. But in the fourth quarter, Treasuries turned around based on Fed policy expectations, resulting in a strong rebound in high yield. With that end-of-year boost, high yield performance in 2023 marginally exceeded that of loans, while double-B CLOs outpaced everything else (see chart).

BB Rated CLOs Ended on Top in 2023

Leveraged finance asset class returns

Source: Bloomberg as of 31 December 2023. Past performance is not indicative of future results. We are not soliciting or recommending any action based on this material. It is not possible to invest directly into an index.

Currently, credit yields have come down from their highs of September 2023 (see chart), but they remain quite elevated and appear attractive – even if spreads have trended down and much more of their yield is coming from the base rate component.

Looking at CLO spreads, we see that on an absolute basis they have tightened along with other credit asset classes but continue to offer a meaningful spread pickup advantage relative to underlying corporates (see chart). As for valuations, it’s important to note that the strong economy resulted in substantially lower defaults for high yield and loans in 2023 than expected at the start of the year, and we expect defaults to remain low this year.

Credit remains compelling

Current strength in the economy stems in part from the strong labor market and extremely low unemployment, driven by massive fiscal stimulus. And even without a much-anticipated recession, inflation has receded, including price declines in the stickier services components – helping the economy glide toward a potential recession-free “perfect landing” of strong employment combined with moderating inflation.

We are aligned with the Fed’s view that the market is overly optimistic regarding the timing and pace of rate cuts, even considering a bit of market sobering of late. Instead of the six to seven rate cuts the market had been pricing in to start 2024, we were in a more cautious camp, expecting a slower pace of three rate cuts.

In addition to some policy easing, we expect to see a slowing of the Fed’s balance sheet runoff starting in midyear, or a tapering of the tapering that could continue through the remainder of the year. Along with gradual Fed easing, we think that should result in a solid, but slowing, economy.

Bottom line? Against this macro backdrop, our base case for the remainder of 2024 is for slowing but stable fundamentals, but credit valuations largely reflect a favorable outcome, particularly in developed markets. Although valuations cannot be characterized as cheap, we see relative opportunities across the credit spectrum, including higher yielding leveraged loans and CLO debt as well as segments of markets that have lagged the rally, such as emerging market credit. And while credit is heading back to a kind of yield-minus outlook with slim opportunities for spread narrowing, yields remain very appealing and offer a fair amount of cushion.

We continue to view credit as a key component in investor portfolios and believe an active, selective approach that merges macro insights with research-based, bottom-up credit selection can help optimize investors’ risk-adjusted returns.