Unlocking markets: is the sun shining after the storm?

Unlocking markets: is the sun shining after the storm?

Andrzej Skiba, Head of US Fixed Income, and Mike Reed, Head of Global Financial Institutions.

Mike Reed 00:04

Hi, and welcome back to Unlocking Markets, our RBC BlueBay podcast series where we bring you our experts from across the firm providing their opinions on the macro environment and discussing how top-down themes help influence the way they invest.

I'm Mike Reed, head of Global Financial Institutions, and today we are joined by Andrzej Skiba, who is head of our US Fixed Income team. Andrzej is based in the US, so it'll be interesting to hear the views of a European who is living and working in the US right now, with so much going on there in terms of politics and the economy currently. Welcome back, Andrzej. Great to have you back on the show.

Andrzej Skiba 00:43

Great to be back indeed. It's a pleasure to join you.

Mike Reed 00:48

Thank you so much. With Q4 now underway, all eyes remain focused on the US and how the largest economy in the world is performing, as obviously this has such a huge impact on the direction of global asset prices. We had violent gyrations in Q2 when President Trump announced his wide-ranging tariffs, and global equities and bonds have both rebounded since then and posted pretty solid Q3 performances. Given the recent strong performance, where do we go from here, and what will be the drivers of fixed income returns?

Andrzej Skiba 01:21

Mike, we think we're going higher from here, at least in total return terms. On our expectations, we could see high single-digit returns, whether you're talking about investment grade or high yield, on a forward 12-month basis, which is a pretty appealing return by historical standards.

The way we get there is a little bit different between the asset classes. With an investment grade, you need some co-operation from a fall in government bond yields on top of a little bit of spread tightening and continued compression. Whereas in high yield, most of that return is accounted for by the carry of the asset class, by the yield of the asset class. In our opinion, high single-digit returns is not something to scoff at. And all this assumes continued rate cuts in the US, but also assumes that US economy actually stabilises, if not accelerates, heading into 2026, something that is our base case at this juncture.

Mike Reed 02:29

Yes, that's quite interesting, actually, because I want to move on and talk a bit about the Fed, and also, as you said, high single-digit returns in an environment where rates are falling or lower is actually quite interesting. As you noted, the Fed has lowered rates already in September by 25 basis points, and the market is pricing in further cuts in the coming months, which should help stimulate the economy.

However, and I'm using the caveat, is that longer-term rates remain elevated, indicating that investors are concerned about inflation? Obviously, this has caused a steepening in the yield curve, and that's worrying some in the market. How do you see this playing out in credit markets over the next 12 months?

Andrzej Skiba 03:13

There are a couple of ways of looking at that. The first perspective is to do with, as you mentioned, the risk of steep curves and what signals does it send to fixed income investors. We think that that becomes a problem only if growth falters. When you have a situation where the US is dealing with an elevated deficit, and at the same time, you have heavy issuance of treasuries, while growth is faltering, that is a toxic combination for fixed income markets. In that world, we would expect continued pressure on fixed income valuations. 

Having said that, this is not our base case scenario. In our view, we are likely to see, as I mentioned, either a stabilisation or actually acceleration of growth in 2026. The case for that revolves around deregulation, so aggressive push from the Trump administration to deregulate and bring back animal spirits into the economy, but also from the cumulative impact of the rate cuts that we expect to see this year and in 2026.

If that were to happen, we do think the market will forgive for elevated levels of deficit running around 6-7% in the US. If growth is your base case assumption, we'll look through that deficit outlook and tolerate these steep curves. At the same time, in that world, it's also worth highlighting that in terms of demand for fixed income securities, as a credit investor, we want curves to remain steep because when we see 10-year, 30-year treasury yields quite high by historical standards, that is what helps to bring a lot of yield-sensitive demand into our market.

It's almost as if investors are saying, "Look, all these rate cuts are being priced at the front end of the curve." That's all nice and dandy, but we don't really care about that too much. What we care about is yields further out the curve. As long as these remain elevated, that helps to create demand for the asset class and money flowing into fixed income assets that should support valuations. As long as growth is stable or improving and yields remain steep, that's actually a strong demand environment for fixed income.

Mike Reed 05:55

I can see that, and the pickup versus overnight rates, it looks quite attractive. You touched on it when we opened about credit spreads. I was looking back through some graphs and some commentary. Investment grade credit spreads are now at their tightest in nearly 30 years. But, as you mentioned, overall yields due to where treasuries are, remain elevated in comparison to their average over the last decade, 15 years.

Do you think that the overall yield was providing sufficient compensation for the low-risk premium available in credit? Is there a chance that maybe we'll even go to where a Microsoft or a Google is actually seen as better credit bases than, say, the US government, so it actually trades through? Is that always a possibility?

Andrzej Skiba 06:40

When we're looking at France, it's already happening with many French corporates trading inside the sovereign. We shall see what kind of roller-coasting politics we're going to have in the US over the coming quarters to see whether that might happen. 

Look, from our perspective, there are two things we can mention. Yes, it is true that spreads, particularly generic spreads, look pretty unappealing at current levels. It would be disingenuous from us to say that there is massive spread tightening potential when you're looking at generic spreads across the market. The good news for us is that, as active investors, we do not have to buy generic spreads. We can focus on those areas that offer pockets of value. Also, we can focus on themes like, for example, compression rates, where subordinated debt is trading at significant discount to senior debt in many of the markets we follow.

As far as we're concerned, yes, it's a horrible environment to go passive, because by going passive, you essentially have to accept these unappealing valuations across all of the cohorts of the market. But if you're an active investor, you can find ways to generate alpha, something that we have done consistently in recent quarters despite relatively tight spreads. At the same time, the focus on historically attractive yields in the asset class.

Mike Reed 08:09

That's good. A nice plug for active investment there. It's true that I think in fixed income, I think many investors don't understand how you can consistently make regular alpha in the market. It is possible by looking at the different areas that exist, I want to look at another way you can generate alpha here. I want to introduce the ‘B’ word.

In recent weeks, we've introduced a couple of high-profile bankruptcies. This is in the US auto sector with both First Brands and Tricolor filing for protection. This has raised obvious concerns about deterioration in the financial health of low income households, maybe worrying some investors that we are seeing a repeat of the pattern that led to the US housing crisis back in 2007, 2008. Do you think these concerns are justified? Is this a canary in the coal mine moment?

Andrzej Skiba 09:01

We think it's actually a false narrative. When you're looking at each of those situations, they're essentially cases of fraud where there is a good possibility because we're still in discovery phase when it comes to each of those situations, but a good possibility that you had double-pledging of collateral, essentially activities that are fraudulent in nature. We will learn about each of these cases over the coming months, but that's the initial gist that we're seeing from press reports and official filings.

However, you are absolutely right that it has increased level of concern about the state of the US consumer, and we're getting a lot of incoming questions whether indeed the situation acts as a canary in a coal mine. When we're actually looking at the data, and you look at consumer data coming from some of the largest providers of consumer credit in the US, we're seeing improvements rather than worsening in data. We're seeing delinquency rates that are falling rather than rising, and net losses, net charge-offs coming down rather than moving higher.

Generally, the information that we're getting from the industry is suggesting improvements rather than worsening. Of course, in recent weeks, there might have been some sudden shift in trends that we haven't seen yet. We will, over the coming weeks, see more incoming data within the space. From what we have seen so far, things are getting better, not worse.

Yes, it's true that particularly the lowest income cohorts have been hard done by by the latest budgets, and they're clearly not seen as winners out of the US budget. However, for most of the other income cohorts in the US, it's been neutral to positive. Assuming that, indeed, the US economy re-accelerates in 2026, we're not seeing too many concerning developments on the horizon.

However, it doesn't give us a license to be complacent. Absolutely, we will continue sifting through data, making sure that we're not anchored in our view that, indeed, the consumer is in robust shape based on what we're seeing. For the time being, taking these two specific cases as something indicating broader malaise, we think is a false narrative.

Mike Reed 11:49

That definitely provides some reassurance. Obviously, it's early days in these two situations, but if they don't create a situation that's more across the board, then that should hopefully be good. I guess one sector that clearly is not benefiting from the new Trump administration's policies is the US shale oil sector.

As increased production out of the Middle East and subdued demand globally, the oil price is now below the level it was before the Russian invasion of Ukraine. With its high marginal cost of production, US shale has become broadly unprofitable at current levels. Instead of drill, baby, drill, it's more shut, baby, shut. Are US shale producers now at risk of default, and how exposed is the US high yield sector to this possibility?

Andrzej Skiba 12:39

I would push back quite strongly against this premise. When you're looking at US energy industry, it has changed dramatically compared to the last major crisis that we've seen back in 2015, 2016. Since then, what we have witnessed is a dramatic fall in leverage within the system. I'm talking about US high yield rather than just investment grade energy exploration companies, but also dramatically improved efficiency i.e. it takes far fewer wells to drill the necessary output, so companies are more profitable.

When you're actually looking at the industry right now, even at current oil prices with WTI around low 60s, the industry is actually profitable. It generates cashflow. It also was actually helped by Trump administration in two ways. The first one to do with permitting. A lot of permitting, the terms have been loosened; for example, they can drill again on federal land.

The other aspect that is to do with the budget, which is probably even more powerful, is major tax benefits for the industry in terms of depreciation and the tax shield it provides that have been put in place. Actually, when you're looking at the sector, it's doing better compared to pre-Trump administration.

Having said that, it is also true that where prices do come down, and it's clearly a risk because OPEC is producing more and more, so there could be a situation where even if US re-accelerates, if the rest of the world is going through pretty unappealing growth outlook, that might put pressure on oil prices. In that world, you will see declines in profitability across the sector.

We believe strongly that US energy can weather that because compared to that old crisis in 2015, '16 that wiped out so many of the companies within the space, back then many issuers were running 3,4,5x leverage. These days, the vast majority of the universe is running 1 or 2x leverage, with 2x being by far the higher end of what we witness across the sector.

The ability of the sector to withstand even lower oil prices is much greater. It doesn't mean that bond prices across the sector will keep moving higher. Of course, they could be under pressure if spot prices are lower, but the default outlook is dramatically different compared to past periods when we've seen oil spot prices under pressure.

Mike Reed 15:33

It's good to hear that they've learned the lessons of a decade ago, and it sounds like they're in a much better position now. Returning to a theme of maybe two decades ago now is, in the last week or two we've had a very interesting market event, and that's been the takeover of EA Sports by a consortium of private buyers, including the Saudi Arabia Public Investment Fund, in what I believe is the largest leverage buyout in history. We talked about it a little bit earlier, but does this signal the start of a new era of animal corporate spirits in the US, and what will be the likely impact on the publicly traded debt if private buyers are back in the game?

Andrzej Skiba 16:17

Yes, it's been fascinating to watch how M&A train is back on, and we're talking about leverage buyouts, public to private buyouts, in a way that we haven't done for quite some time. We absolutely agree. We do believe that now that you have clarity in the US on the topics of taxation, mostly on the topic of trade, issuers are more free to make investment decisions, including when it comes to M&A.

We do expect a meaningful pickup in M&A activity over the coming quarters. We're already seeing that happening, not just when it comes to the EA leverage buyout, but multiple other transactions announced in recent weeks. We think this is just the beginning, and it will be further helped by rate cuts lowering the cost of funding going forward.

When it comes to leverage buyout transactions, we expect the trend to be similar to the past, where those transactions are funded in the floating markets. A vast majority of the funding should happen across the leveraged loan space and private credit space, with a small portion of that deal flow hitting bond markets.

Having said that, where it matters is in terms of companies that are being the targets of these acquisitions, especially if the acquisition will lead to more leverage. Most bonds have change of control provisions these days. However, many bonds are trading well above those levels at prices that are meaningful higher than that.

There could be downside for investors from prices coming down to change of control levels, and we're spending a fair amount of time with our analysts identifying who will be the acquirers and who are likely to be the targets. We had to dust off our LBO return screens that we haven't used for quite a number of years, but we're absolutely focused on this theme, and we expect an increase in activity, especially knowing that markets are wide open for financing.

The ability of issuers to fund deals, whether it's an investment grade or high yield markets, is very substantial right now. It's very important to choose who could be targets of those acquisitions where that could actually lead to improvement of credit quality or bonds being taken out, and which names are vulnerable to prices actually coming down towards change of control as a result of the acquisitions, and which issuers want to reset their capital structure to a high level of leverage to accommodate an acquisition. A lot of work for our teams, but quite an exciting theme that we only expect to increase in scale over the coming quarters.

Mike Reed 19:21

That's very interesting. Again, touching on the active versus passive, having the teams around you, obviously with the experience, as you alluded to, that have been through this cycle before, and dusting off old models and knowing what's happened before is really, really important. It's not just about picking the winners. It's avoiding the losers. That really helps you generate alpha.

It's clear that there are so many different dynamics in the US, both in the politics and the economy itself. It'll be interesting to see how you and the team navigate the various investment currents. I greatly appreciate you coming back on the show. It's been thought-provoking to hear your insights and understand what you are going to be doing to generate returns for clients in what sounds like a market full of alpha-generating opportunities. Thanks, Andrzej.

Andrzej Skiba 20:08

Always a pleasure. Thank you.

Mike Reed 20:10

So many thanks for listening to the show. If you've enjoyed it, please like and subscribe on your podcast platform of choice. We will be back soon. We'll be joined by our CIO, Mark Dowding. With his views on global markets and insights gained from meetings with central banks across the world, he is always worth listening to. If you wish to listen to any of the previous editions of the Unlocking Markets podcast, they are also available on our website www.bluebay.com, or can be found on Apple, Spotify, or Google. Thank you once again for joining us today. Good luck and goodbye.