UBS braces for hard landing in US credit

Bloomberg

UBS Group AG is recommending investors to buy European credit over US debt amid signs of distress in the US loan markets, cracks emerging in private credit and a potentially severe downside risk in US high-yield debt.
“We acknowledge US high yield is better positioned — mainly on the shift in credit quality,” UBS analysts led by Matthew Mish wrote in a note. “However, we still believe credit is heading for a hard landing.”
The riskiest corners of US credit are already flashing some warning signals for a hard landing, according to the analysts. An abrupt reversal in the economy — where company profit growth dovetails with higher borrowing costs and tighter access to credit — could push loan default rates to about 9% by the end of 2023 while junk defaults reach 6.5%. The share of CCC rated loans increased notably in the fourth quarter as downgrades accelerated to 7.5% from 5.4%.
Money managers that purchase loans and bundle them into bonds known as collateralised loan obligations (CLO), meanwhile, are avoiding more of the troubled companies for now. CLO CCC exposures rose less than the broader market, to 5% from 4.2%. Both US leveraged loan and CLO spreads have lagged junk since the third quarter, consistent with higher risk aversion in loans. CCC loan prices, meanwhile, have underperformed BB bonds, putting incremental pressure on recovery values, according to the Swiss bank.
“Overall we think refinancing capacity remains constrained with leveraged loan 2024-2025 maturities on the horizon,” wrote the analysts. “On balance, we view recent developments as marginally negative.”
Defaults have yet to pick up in leveraged loans and junk markets but the bank is starting to see signs of rising private credit defaults — to about 5% — inclusive of soft credit events like covenant breaches. The development is consistent with the rapid growth in the middle market coupled with the concentration in lowest rated loans and higher dependence on floating rate debt, the analysts wrote.
The US junk market isn’t pricing in even a mild recession, said the analysts. The bonds have gained for a fifth straight session, and yields have fallen to 8.03%, the lowest since late August. Average junk spreads ended at 416 basis points, about 53 basis points tighter than where they were at the end of 2022, according to Bloomberg indexes. The analysts acknowledge the junk market is better positioned, mainly on the shift in credit quality but says the risk to the downside is severe.
UBS remains tactically cautious on credit spreads at current levels. They are underweight CCC rated debt and overweight BBs. They also favour sectors more insulated from default risks, including utilities, staples and industrials.