We believe the key credit market themes of 2022, such as stubborn inflation, rising global interest rates and the war in Ukraine, will continue to drive market volatility into 2023. Inflation remains well above recent historic levels, with CPI prints over 7% in the U.S. and over 10% in Europe. The federal funds rate reached 4.5% at the end of 2022, which is more than 400bps higher than at the start of the year. In December 2022, the European Central Bank (ECB) raised rates for the fourth time in 2022, after not raising them for the past 11 years. Both the Federal Reserve (Fed) and the ECB are expected to continue raising rates well into 2023. And the war in Ukraine remains unresolved and continues to be a major headwind for the global economy and for Europe especially.

Worsening economic conditions impacted credit market returns in 2022. However, this did not result in a corresponding large increase in defaults as one might have expected. Through the end of November 2022, the high yield market was down -10.54% and the 12-month high yield default rate was only at 1.47%.¹ While spreads in the high yield market widened since the beginning of 2022 to 455 bps,²  they had not widened out to historic recessionary levels (over 800 bps on average) by the end of November. This indicates that the traditional risk transfer that usually occurs during most market dislocations from par holders to stressed buyers of credit has largely not taken place. In addition, it is very likely that spreads and prices may see further downside volatility in 2023. This opinion is reinforced by the forecasted doubling of speculative-grade credit default rates in 2023 by Moody’s.³  As illustrated in the following chart, the percentage of single-B and lower-rated credits has grown to over 70% of the leveraged loan market over the past few years, thus this forecast appears to be attainable.⁴  If higher interest rates coupled with economic headwinds negatively impact weaker credits as expected, especially in Europe, opportunities in the credit special situations market should increase significantly in 2023.

Leveraged loan market: % of single-B and lower-rated loans (by par amount)

Chart source: LCD U.S. Leveraged Loan Index; as of 11/30/22.

With the cold weather of winter, a further divergence is possible between the economic conditions of the U.S. and Europe. In the U.S., inflation, while still elevated, seems to have peaked as illustrated by easing freight and transport costs for many businesses. Europe is a different story as the continent’s dependence on foreign, and primarily Russian, energy may cause inflationary pressures to stay elevated in the near term. This has made it difficult for European businesses to provide accurate forward guidance. In response, we have been more focused on U.S. opportunities and expect this to continue in the early months of 2023. Over the medium term, we anticipate a greater distressed opportunity set in Europe once the negative impact of these headwinds is more accurately reflected in credit markets.

In summary, while there will be unique investment opportunities in the public credit markets, we believe bespoke private transactions, where risks and protections can be more closely monitored and negotiated, offer the best risk/return trade-offs in the current market. From a geographic standpoint, our investment focus is skewed toward short-dated, event-driven transactions in North America. Over the medium to long term, we expect this focus to shift toward Europe as a larger distressed opportunity set may become available there following the winter months.

¹ ICE BofAML US High Yield Index; as of 11/30/22.
² ICE BofAML US High Yield Index; as of 11/30/22.
³ Moody’s Investor Services. 2023 Outlook: Issuance to pick up from record low while credit quality weakens.
⁴ LCD US Leveraged Loan Index, Pitchbook; as of 11/30/22.