US IG & Leveraged Finance 2H24/1H25 Outlook

Stuck in Neutral for Fixed; More Cautious on Floating

We maintain our Market Weight allocation to US IG and HY credit, though we acknowledge that excess return prospects for spread-focused buyers are far less compelling than total return upside. We are moving our Leveraged Loan recommendation to Underweight (from Market Weight) as we see the potential for further fundamental erosion, rating downgrades, return headwinds from declining base rates (Floating Away: Understanding Loan vs. Bond Yields) and an elevated default rate as key risks to the market.

Forecast Expectations for 2H24 and 1H25:

• Rates
  • We expect the Fed will cut rates 75 bp in 2024 with the upper end of the Fed funds target range to finish the year at 4.75%. In our view, Fed policymakers have taken a July cut off the table with the latest Summary of Economic Projections (SEP) and subsequent public commentary. In other words, we expect the first cut in September and for the Fed to cut 25 bp at each meeting for the remainder of the year. Our base case is the Fed continues cutting at every meeting in the first half of 2025, putting the upper end of the Fed funds target range at 3.75% at the end of June 2025.
  • Our call is more dovish than current market pricing, with the June 2025 SOFR futures contract implied rate at 4.29%. This is driven by our expectation for more disinflation, amid a larger than consensus slowdown in the US consumer (more details on that below).
  • With an economic slowdown, we expect long-end UST yields to also fall, pushing the 5Y and 10Y UST yield to 3.75% through YE 2024 and further down to 3.25% in 1H25. We expect the 2Y UST yield will initially move in tandem with the intermediate/long-end, declining to 3.75% by year-end and even lower, towards 3.0%, by June 2025. This implies a flat 2s/10s curve at the end of 2024, followed by modest bull steepening toward +25 bp through 2Q25.
  • We are comfortable with our call for Treasury yields across the curve to fall more than consensus and forwards price, as the market currently prices too high of a ‘neutral rate’ in our view. SOFR futures flatten out around 3.6% beginning in September 2026. Our base case is the neutral policy rate is close to 2.75-3.00% and given our expectation for a more notable economic slowdown beginning in 2H24, we think the Fed may be forced to take the policy rate back to that level more quickly than the market currently appreciates.

• Spreads & Returns
  • Defensive Carry: At long last, we are taking a more cautious tilt on our spread calls, anticipating further widening across US IG, HY and leveraged loans through 1H25. We are maintaining our YE 2024 forecast of 100 bp for IG and 350 bp for HY, with the expectation that markets overshoot those targets, potentially in the seasonally weaker months of August through October.
  • 1H25 CreditSights View: Our base case spread forecast for 1H25 implies further widening, with IG moving toward 120 bp and HY to 400 bp. We anticipate some modest erosion in leveraged loan prices, falling toward $93.50, largely on lower-rated issuers. We believe that corporate credit fundamentals are at an inflection point and that markets are likely to see some modest erosion amid a deceleration in economic growth. We assign a 55% probability to our base case CreditSights View.
  • Bear Cases: We maintain two key bear case scenarios, Stagflation and a Hard Landing. We’d like to take a moment to recognize our Stagflation scenario is really quite watered down relative to the only other true stagflation period in the 1970s and 1980s. For simplicity, we leave the name the same, but appreciate that perhaps it should just be called a sticky inflation/inflation reacceleration scenario, especially considering how strong economic growth has been. Either way, we continue to believe that the likelihood of ‘Stagflation’ is greater than a true hard landing and assign a 20% probability to Stagflation versus only 10% for Hard Landing. We view the outcome of the US election as a potential driver of a Stagflation-like outcome in either a Red or Blue wave, which would likely come with more significant policy changes, pressure on the US deficit and a renewed focus on UST supply.
    • In our Stagflation scenario, we expect that the Fed would need to restart a hiking cycle, driving IG spreads toward 150 bp and HY to 400 bp amid a material shift higher in UST yields. This scenario would prove very challenging for corporate credit with excess and total return losses for IG, negative leveraged loan returns and very modestly positive HY total returns. In an elevated inflation environment, investors would benefit from sticking with front-end, higher yielding market segments for higher quality asset classes, like BBBs and BBs (US Strategy: Avoiding Portfolio ‘Shrinkflation’).
    • In a hard landing, we expect IG spreads to widen toward 200 bp, while HY would underperform meaningfully, with spreads widening to 750 bp. IG excess returns would turn very negative in a hard landing, but the big drop in UST yields would support double-digit IG total returns and modestly positive HY total returns. Leveraged loans would fare the worst in this scenario as falling base rates combined with a decline in dollar prices would result in low double-digit return losses.
  • Bull Case: We continue to believe that the Fedspeak View, using the Fed’s Summary Economic Projections as a guide, is the bull case for corporate credit. In this scenario, we anticipate further spread tightening, to 75 bp in IG and 275 bp in HY, representing new cyclical tights, while loan prices would rise toward $98.50. This would mark the highest level since early 2022. We are notching down the probability of this bull case scenario, to 15% from our previous bull case at 25%, as we have already begun to see some signs slowing economic momentum, especially in consumer-linked sectors.
• New Issue Supply
  • US IG & HY – Maintaining Forecasts: We are maintaining our expectation of $1.5 trillion and $275 billion of IG and HY issuance in 2024, implying an additional $651 billion and $95 billion remaining for the year. We continue to expect that IG issuers will work to address near-term maturities as almost $2 trillion in bonds will mature in 2025-2026, while HY has done a solid job of pushing out maturities, meaningfully reducing debt due in 2025 and 2026 with recent issuance (US Chart of the Day: IG, HY & LL Maturity Walls).
    • For IG, our forecast implies a monthly issuance run rate of $108.5 billion, a downshift from the YTD monthly average of $141.5 billion. Financials issuance is expected to decelerate with our banks team calling for another $40-50 billion of supply from the Big 6 while Cat. IV bank issuance is already up 12% YoY.
    • For HY, our forecast implies a monthly issuance run rate of $15.8 billion, just over half of the YTD monthly average of $30 billion. We expect that a shrinking HY market should prove a supportive technical factor (US HY: The Incredible Shrinking Asset Class) as the market remains highly aligned to refinancing, rather than new money, issuance.
  • Leveraged Loans – Bumping Higher: We are (again) upping our forecast for broadly syndicated loan market issuance, to $400 billion from $350 billion, as YTD activity (excluding pure repricing/extension deals) already totals $270.8 billion. This has helped to extend maturities, especially those in 2024-2026.
    • For now, we expect that activity remains geared to refinancing activities as the pipeline for M&A and LBO transactions has been somewhat slow to build.
    • Our $400 billion forecast implies $129 billion of remaining loan issuance, or a monthly pace of $21.5 billion; this compares to a YTD monthly average of $45.1 billion.
• Defaults: In our base case, we expect defaults to remain elevated around current levels for both HY and leveraged loans. Loan defaults have been outpacing bond defaults on an issuer-weighted basis, and we expect that to persist. We see liability management exercises and distressed debt exchanges as the most likely driver of defaults over the next 12 months and highlight a list of potential LME candidates on slide 28.

Investment Themes for 3Q24/1H25

• Curve Positioning: Curve positioning has proven challenging for US credit investors as UST yields continue to trade in a relatively wide range and persistent curve inversion limits appetite for duration extension. We continue to recommend a barbell strategy, especially in US IG, though we like adding duration to yield-focused portfolios as we see 10Y UST yields above 4.25% as an attractive entry point. We note that spread/excess return focused investors should exercise some caution when moving out the curve as very long-end spreads for lower rated issuers are likely to underperform; however, total return prospects in the long-end are quite compelling (US Strategy: Get Shorty – US IG Curve Performance ).
• Rating Preference:
  • For IG, total and excess return prospects are brightest for AAAs and AAs, though A-rated Financials remain a top pick overall. We recommend beginning to pare back outsized exposure to BBBs, which have the highest potential to generate negative excess returns in our core forecast.
  • In HY, we prefer an up in quality strategy focused on adding yield by extending out the curve. Long-end BBs have the greatest potential to outperform given our expectations for wider spreads/falling yields. In our base case forecast, the range of potential total return performance across BBs, Bs and CCCs is relatively narrow, meriting an up in quality strategy.
• Sector Strategy: While we are maintaining a Market Weight allocation to US IG, we see sector strategy as a way to position more defensively. In HY, our sector strategy has a cautious bias as we have downgraded some recent strong performers and see fewer opportunities for outperformance driven by sector strategy.
  • Outperform:
    • Within US IG, we are maintaining our Outperform recommendation on Financials, including Large and Regional US Banks and Insurance; we are also holding our Outperform recommendation on Basics as our analysts expect a restocking cycle to help support valuations, which still trade wide to the broader index.
    • We currently have no Outperform recommendations in HY as sectors with outsized spread pick-up remain fundamentally challenged and performance will likely be driven by a handful of storied issuers.
  • Underperform:
    • For US IG, our valuation-driven Underperform recommendations include Autos and Retail, both of which trade at meaningfully tight spreads relative to the broader index and could face some fundamental headwinds amid decelerating consumer demand. IG Media remains our sole fundamentally-driven Underperform as the sector remains under pressure from structural changes and potential fallen angel candidates drag spreads wider.
    • Our HY sector strategy has a slight bias to Underperform recommendations on Autos, Consumer Goods and Retail. These sectors trade tight to the broader HY index while fundamental headwinds are likely to increase in the consumer-aligned sectors.
  • Shift to Market Perform:
    • In IG, we are upgrading Capital Goods and Technology to Market Perform; despite tight spreads, these two sectors have ‘cheapened’ relative to higher beta market segments, providing an attractive opportunity to position for defensive carry in higher quality sectors.
    • In HY, we are downgrading Leisure and Health Care, two sectors that have posted a strong streak of performance, and Media, where fundamental challenges are likely to persist.
  • For a full overview of our US IG & HY Sector Strategy, including links to sector-by-sector views from the CreditSights analyst team, see 3Q24/1H25 US IG & HY Sector Strategy Overview.

Risks to the Outlook

• Near-Term (3-6 Months): In the near-term, we remain keenly focused on heavy UST supply, particularly ahead of the US election. If it begins to appear that unified government is a likely election outcome (Red or Blue Waves), we would expect fiscal deficit concerns to again become a top-of-mind issue, ushering in another dreaded bear steepener and driving corporate credit spreads wider. We also remain keenly focused on economic data, particularly as it relates to the consumer. While some bright spots remain in the consumer complex (Cruise: Rising Tides & Stars), recent retail traffic and spending patterns highlight a shift to value seeking behavior (U.S. Consumer Goods: 1Q24 Spending Patterns). With the consumer driving economic momentum in 2023, signs of weakness may result in an over-correction with markets again pricing in a recession, rather than normalization.
• Medium-Term (6-12 Months): In the medium-term, a reacceleration of inflation (especially if coupled with a perceived inflationary red wave in the US election) could force the Fed to hike rates further, driving concerns of elevated borrowing costs and weighing on risk sentiment, especially for more leveraged capital structures. Further geopolitical escalations could add to these factors by pushing commodity prices higher.
• Long-Term (1-2 Years): Further out, we have some concerns about the recent risk taking behavior in the broadly syndicated loan and private credit markets, as covenant protections have eroded meaningfully amid recent competition for deals. Spreads in both the BSL and Private Credit market have also repriced tighter, leaving us concerned about the risk/return profile in the space currently. When combined with falling base rates and a potential for higher defaults, return prospects may prove less compelling than in recent history, especially for private credit (see U.S. TrendLines: Price and Covenant Flex Favors Borrowers in June even as Secondary Weakens and Private Credit: Part III – Future of the Market). Another concerning development is the use of LME in the private credit space (US Special Situations: PluralSight raises preferred equity, conducts drop-down liability management transaction). In our view this calls into question one of the hallmark’s of stability in private credit – close relationships among lenders/borrowers. Increased focus on drawing in retail money through the use of semi-liquid structures and interval funds leave us more worried about the potential for a future liquidity crunch if the private credit market falters. We also have questions about the sustainability of the recent AI craze, especially in the context of the focus on ESG amid rising electricity demand (Datacenter Nat. Gas Demand Growth: Gross or Net?).