Western Asset: 2Q23 Global Credit Monitor

Western Asset’s Global Credit Monitor provides fixed-income investors with our holistic assessments of trends, technicals and relative value across the entirety of the global credit market.

Macro Perspective

In line with our expectations, global growth appears to be downshifting and inflation is trending lower. Declining new-order activity, rising inventories and improving supply chains worldwide have resulted in lower manufacturing inflation. Signs of moderating price pressures are also evident across service sectors globally. These trends, combined with the major central banks continuing to advocate for tight monetary policy, should further temper growth and inflation. As global growth and inflation continue to moderate, and recent concerns over the stability of the US and EU banking systems abate, we expect developed market (DM) government bond yields to trend lower. In such an environment, we anticipate that the US dollar will weaken modestly and that emerging markets (EM)—where central banks are at the end of their tightening cycle—should outperform. We believe credit markets currently offer attractive value but acknowledge that they remain vulnerable to unanticipated shifts in macro-related sentiment, geopolitical developments and the risk of central bank overtightening.

Global Credit Markets: Relative Value Round-Up Banking Sector Update
Regulators and bank management teams have both learned valuable lessons and helped to significantly de-risk the banking business model since the global financial crisis. This became evident during the pandemic when banks showed that they had been transformed from “causing a crisis” to becoming “part of the solution.” However, several recent bank failures have also highlighted that more work needs to be done. Overall, we continue to remain constructive on banking sector credit fundamentals against a backdrop of heightened uncertainties. Within the sector, we continue to have a clear preference for high-quality names. We favor the fundamentally strongest banks globally based on their less risky business models as well as higher resilience to heightened economic uncertainties, the impact of higher rates on securities portfolios as well as their much more conservative exposure to more vulnerable sectors such as commercial real estate. In addition, the stricter regulatory and supervisory rules that these banks are subject to provide added protection to bondholders. We believe the market will increasingly conclude that banking regulation has been largely successful for the highly regulated global systemically important banks, that regional bank business models will need to be de-risked, and that regulators have the tools, willingness and ability to stabilize the banking system’s confidence crisis. As a result, we do expect greater differentiation between the strongest and weaker banks going forward when it comes to business model evaluations, ratings and market pricing. This is another reason why we favor exposure to the strongest banks. Exhibit 1: The Two Tiers of the US Banking System—We Prefer Large US Banks Over Regionals (Select the image to expand the view.)
Another Crisis, More Inflows to Government Money Market Funds
In response to the sudden deposit flight from Silicon Valley Bank and Signature Bank—and what became the second and third largest bank failures in US history, respectively—money market funds (MMFs) experienced record inflows. Recently, the Investment Company Institute (ICI) reported a net increase in MMF assets in the US of around $120 billion, driven by nearly $145 billion of inflows to Government MMFs, partially offset by outflows from Prime and Tax-Exempt MMFs. This increase has taken the US MMF industry assets to a record level of just over $5 trillion. Exhibit 2 shows the growth in the Government and agency institutional MMF category over early 2020 and the past six months, including March 2023. Why Are Government MMFs So Attractive to Investors? Both retail and institutional investors commonly use Government MMFs, and their appeal can be explained by their robust regulatory framework, widespread availability for trading (providing ease of access and use), their competitive yields relative to bank deposits and other cash products, and the very high quality of their portfolio holdings. A critical feature for Government MMFs’ appeal to investors is their ability to maintain a NAV of $1.00 and trade through similar mechanisms as bank deposit products. This feature allows the funds to be offered across a wide range of retail and institutional platforms as alternatives to deposits and other money market securities. These include institutional and retail brokerage, custody, trust, commercial bank and other sweep platforms, and also trading via MMF portals or directly with a fund’s transfer agent. Exhibit 2: Growth in Government and Agency Institutional MMFs: Early 2020 and 2022-2023 (Select the image to expand the view.) Their wide availability helps position Government MMFs as a convenient product alternative for cash investors, whether for day-to-day expenses, asset allocation or temporary defensive purposes. In turn, banks often support the availability of Government and other MMF strategies to their clients as an outlet to move unwanted cash away from their balance sheets. Government MMFs are effective pass-through investments for monetary policy, allowing cash investors to benefit from increases in the fed funds rate. As overnight money market securities—including US Treasury bills (T-bills), short-term government agency debt and repurchase agreements—reset their yields at higher levels in response to the Fed’s interest rate hikes, Government MMFs holding shorter average portfolio maturities have been able to pass on higher short-term rates to cash investors at a relatively fast pace. See our recent blog post for more details about how the banking turmoil in March impacted Government MMFs. Investment-Grade (IG) Credit Corporate fundamentals have peaked and earnings will likely decelerate given tighter financial conditions, rising input costs and a spent consumer. Against that backdrop, corporate managements continue to behave conservatively given uncertainty with the macro environment. Many firms also termed out a good portion of their debt stack in Covid’s immediate aftermath at much lower coupons leaving their balance sheets less vulnerable to higher rates. The current banking system stress, while complex, should not be systemic and volatility there should eventually abate. We continue to maintain overweights to banking, energy, select reopening industries and rising-star candidates. In Europe, corporate fundamentals are robust. Bank balance sheets are strong but deposit flight and counterparty risks expose fragilities in the system. Demand for credit at higher yields may be tempered by banking sector concerns in the near term. Recent widening of IG credit spreads leaves valuations reasonably attractive but volatility is likely to persist. We see attractive opportunities in high-quality banks and select real estate sectors such as logistics. High-Yield (HY) Credit In the US, HY credit spreads are relatively attractive. Default rates are likely to rise from very low levels in the coming quarters, but yields are providing ample cushion for higher defaults, which are likely to be below historical averages given the higher credit quality of the market on average. Technicals have been negative over the last year given outflows from mutual funds, but higher yields are beginning to attract new institutional buyers. We continue to see opportunity in service-related sectors that are still recovering from the Covid-led recession (i.e., reopening trades including airlines, cruise lines and lodging) and potential rising stars. We are more cautious on companies with closer ties to housing-related activity and therefore lack pricing power. In Europe, corporate fundamentals are facing fewer headwinds than feared as growth is holding up better than expected and energy costs are subsiding. Concerns are shifting toward the impact of tighter financial conditions. Issuance remains subdued but is anticipated to increase as 2024/2025 maturities need to be refinanced. We continue to focus on BB and B rated credits and short-dated yield to call bonds and industries in defensive sectors. Bank Loans and Collateralized Loan Obligations (CLOs) Bank loan spreads are relatively attractive. While fundamentals are expected to decline from robust levels as growth slows, yields are providing ample cushion for gradually higher defaults. Valuations have improved meaningfully, and technicals may soon improve as demand for discounted floating-rate loans from CLOs may exceed moderate new-issue supply. We believe outperformance will come from credit selection and avoiding problem credits. We are focused on select names where fundamentals remain intact and prices are at discounts to their call price. In the CLO sector, any improvement in the CLO arbitrage or reduction of broader macro volatility is likely to be met with CLO issuance, keeping spreads relatively range-bound in the near term. Hedging costs for overseas investors have risen over the last few quarters, but high-quality CLOs still screen attractive for overseas investors, which should lead to demand. We view AAA rated CLO debt at current levels as very attractive and retain our view that it will continue to perform well in either bullish or bearish bank-loan-spread environments given strong structural protections. Municipals Municipals continue to offer compelling value for investors subject to tax rates. As markets price in peak Fed rate hikes, we anticipate investors (post tax season) will re-evaluate attractive after-tax relative valuations and improving fundamentals of the asset class. We favor longer duration securities that offer higher spreads and could benefit from an economic slowdown. Following the Q1 flight-to-quality sentiment, lower-investment-grade-rated securities stand to benefit from the sector’s improving credit trajectory. Mortgage and Consumer Credit Rising mortgage rates have put downward pressure on housing affordability, resulting in a reduction of housing demand. In conjunction, housing supply continues to normalize through an ease in supply-chain issues and new-home completions. While housing is expected to cool, we do not see a significant risk of defaults. In the residential mortgage-backed space, due to the increase in new-issue supply, we are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals. In the commercial mortgage-backed space, attractive yields are available across the capital stack for high-quality credits but rates-driven volatility remains. Fundamental performance is positive with limited distress outside of the office sector. Limited supply in fixed-rate paper will support spreads while high-quality floating-rate credits are available at attractive levels, both new issues at par and discounted seasoned bonds. Subordinate credit relative value screens particularly cheap but performance will be idiosyncratic. Emerging Markets (EM) EM resilience amid significant banking stress in DM countries underscores supportive macro developments (commodity prices and orthodox policies). That said, key risks include evolving idiosyncratic factors and geopolitics. Credit differentiation across the diverse mix of countries is key to extracting long-term value. In the EM sovereign space, valuations in select higher-yielding frontier market sovereigns continue to look attractive. Turning to EM local markets, monetary tightening since early 2021 has provided EM local debt a strong buffer to exogenous shocks. Notwithstanding expectations of inflation rolling off in the second half, central banks have maintained a prudent stance, reducing the risk of premature easing. While noting that foreign exchange (FX) tends to be highly macro-driven, we see tactical value in select EM currencies with favorable fundamental traits. The moderating trend in price pressures is supportive of EM local rates. Finally, balance sheet strength of EM corporates will continue to underpin asset prices. Risks to the sector are primarily sovereign-driven (e.g., regulatory changes and geopolitical headwinds). We look for opportunities in the primary market to extract a new-issue premium in high-quality credits. EM corporates’ lower duration and volatility continue to represent an attractive risk/reward proposition.

Global Credit Markets: Relative Value Round-Up *Within the banking sector, we continue to have a clear preference for high-quality names.*	Banking Sector Update Regulators and bank management teams have both learned valuable lessons and helped to significantly de-risk the banking business model since the global financial crisis. This became evident during the pandemic when banks showed that they had been transformed from “causing a crisis” to becoming “part of the solution.” However, several recent bank failures have also highlighted that more work needs to be done. Overall, we continue to remain constructive on banking sector credit fundamentals against a backdrop of heightened uncertainties. Within the sector, we continue to have a clear preference for high-quality names. We favor the fundamentally strongest banks globally based on their less risky business models as well as higher resilience to heightened economic uncertainties, the impact of higher rates on securities portfolios as well as their much more conservative exposure to more vulnerable sectors such as commercial real estate. In addition, the stricter regulatory and supervisory rules that these banks are subject to provide added protection to bondholders. We believe the market will increasingly conclude that banking regulation has been largely successful for the highly regulated global systemically important banks, that regional bank business models will need to be de-risked, and that regulators have the tools, willingness and ability to stabilize the banking system’s confidence crisis. As a result, we do expect greater differentiation between the strongest and weaker banks going forward when it comes to business model evaluations, ratings and market pricing. This is another reason why we favor exposure to the strongest banks. Exhibit 1: The Two Tiers of the US Banking System—We Prefer Large US Banks Over Regionals Another Crisis, More Inflows to Government Money Market Funds In response to the sudden deposit flight from Silicon Valley Bank and Signature Bank—and what became the second and third largest bank failures in US history, respectively—money market funds (MMFs) experienced record inflows. Recently, the Investment Company Institute (ICI) reported a net increase in MMF assets in the US of around $120 billion, driven by nearly $145 billion of inflows to Government MMFs, partially offset by outflows from Prime and Tax-Exempt MMFs. This increase has taken the US MMF industry assets to a record level of just over $5 trillion. Exhibit 2 shows the growth in the Government and agency institutional MMF category over early 2020 and the past six months, including March 2023. Why Are Government MMFs So Attractive to Investors? Both retail and institutional investors commonly use Government MMFs, and their appeal can be explained by their robust regulatory framework, widespread availability for trading (providing ease of access and use), their competitive yields relative to bank deposits and other cash products, and the very high quality of their portfolio holdings. A critical feature for Government MMFs’ appeal to investors is their ability to maintain a NAV of $1.00 and trade through similar mechanisms as bank deposit products. This feature allows the funds to be offered across a wide range of retail and institutional platforms as alternatives to deposits and other money market securities. These include institutional and retail brokerage, custody, trust, commercial bank and other sweep platforms, and also trading via MMF portals or directly with a fund’s transfer agent.
*Recent widening of IG credit spreads leaves valuations reasonably attractive but volatility is likely to persist.*	Exhibit 2: Growth in Government and Agency Institutional MMFs: Early 2020 and 2022-2023 Their wide availability helps position Government MMFs as a convenient product alternative for cash investors, whether for day-to-day expenses, asset allocation or temporary defensive purposes. In turn, banks often support the availability of Government and other MMF strategies to their clients as an outlet to move unwanted cash away from their balance sheets. Government MMFs are effective pass-through investments for monetary policy, allowing cash investors to benefit from increases in the fed funds rate. As overnight money market securities—including US Treasury bills (T-bills), short-term government agency debt and repurchase agreements—reset their yields at higher levels in response to the Fed’s interest rate hikes, Government MMFs holding shorter average portfolio maturities have been able to pass on higher short-term rates to cash investors at a relatively fast pace. See our recent blog post for more details about how the banking turmoil in March impacted Government MMFs. Investment-Grade (IG) Credit Corporate fundamentals have peaked and earnings will likely decelerate given tighter financial conditions, rising input costs and a spent consumer. Against that backdrop, corporate managements continue to behave conservatively given uncertainty with the macro environment. Many firms also termed out a good portion of their debt stack in Covid’s immediate aftermath at much lower coupons leaving their balance sheets less vulnerable to higher rates. The current banking system stress, while complex, should not be systemic and volatility there should eventually abate. We continue to maintain overweights to banking, energy, select reopening industries and rising-star candidates. In Europe, corporate fundamentals are robust. Bank balance sheets are strong but deposit flight and counterparty risks expose fragilities in the system. Demand for credit at higher yields may be tempered by banking sector concerns in the near term. Recent widening of IG credit spreads leaves valuations reasonably attractive but volatility is likely to persist. We see attractive opportunities in high-quality banks and select real estate sectors such as logistics. High-Yield (HY) Credit In the US, HY credit spreads are relatively attractive. Default rates are likely to rise from very low levels in the coming quarters, but yields are providing ample cushion for higher defaults, which are likely to be below historical averages given the higher credit quality of the market on average. Technicals have been negative over the last year given outflows from mutual funds, but higher yields are beginning to attract new institutional buyers. We continue to see opportunity in service-related sectors that are still recovering from the Covid-led recession (i.e., reopening trades including airlines, cruise lines and lodging) and potential rising stars. We are more cautious on companies with closer ties to housing-related activity and therefore lack pricing power. In Europe, corporate fundamentals are facing fewer headwinds than feared as growth is holding up better than expected and energy costs are subsiding. Concerns are shifting toward the impact of tighter financial conditions. Issuance remains subdued but is anticipated to increase as 2024/2025 maturities need to be refinanced. We continue to focus on BB and B rated credits and short-dated yield to call bonds and industries in defensive sectors.
*We view AAA rated CLO debt at current levels as very attractive and retain our view that it will continue to perform well.*	Bank Loans and Collateralized Loan Obligations (CLOs) Bank loan spreads are relatively attractive. While fundamentals are expected to decline from robust levels as growth slows, yields are providing ample cushion for gradually higher defaults. Valuations have improved meaningfully, and technicals may soon improve as demand for discounted floating-rate loans from CLOs may exceed moderate new-issue supply. We believe outperformance will come from credit selection and avoiding problem credits. We are focused on select names where fundamentals remain intact and prices are at discounts to their call price. In the CLO sector, any improvement in the CLO arbitrage or reduction of broader macro volatility is likely to be met with CLO issuance, keeping spreads relatively range-bound in the near term. Hedging costs for overseas investors have risen over the last few quarters, but high-quality CLOs still screen attractive for overseas investors, which should lead to demand. We view AAA rated CLO debt at current levels as very attractive and retain our view that it will continue to perform well in either bullish or bearish bank-loan-spread environments given strong structural protections. Municipals Municipals continue to offer compelling value for investors subject to tax rates. As markets price in peak Fed rate hikes, we anticipate investors (post tax season) will re-evaluate attractive after-tax relative valuations and improving fundamentals of the asset class. We favor longer duration securities that offer higher spreads and could benefit from an economic slowdown. Following the Q1 flight-to-quality sentiment, lower-investment-grade-rated securities stand to benefit from the sector’s improving credit trajectory. Mortgage and Consumer Credit Rising mortgage rates have put downward pressure on housing affordability, resulting in a reduction of housing demand. In conjunction, housing supply continues to normalize through an ease in supply-chain issues and new-home completions. While housing is expected to cool, we do not see a significant risk of defaults. In the residential mortgage-backed space, due to the increase in new-issue supply, we are opportunistic on credit risk transfer (CRT) securities as well as non-QM deals. In the commercial mortgage-backed space, attractive yields are available across the capital stack for high-quality credits but rates-driven volatility remains. Fundamental performance is positive with limited distress outside of the office sector. Limited supply in fixed-rate paper will support spreads while high-quality floating-rate credits are available at attractive levels, both new issues at par and discounted seasoned bonds. Subordinate credit relative value screens particularly cheap but performance will be idiosyncratic. Emerging Markets (EM) EM resilience amid significant banking stress in DM countries underscores supportive macro developments (commodity prices and orthodox policies). That said, key risks include evolving idiosyncratic factors and geopolitics. Credit differentiation across the diverse mix of countries is key to extracting long-term value. In the EM sovereign space, valuations in select higher-yielding frontier market sovereigns continue to look attractive. Turning to EM local markets, monetary tightening since early 2021 has provided EM local debt a strong buffer to exogenous shocks. Notwithstanding expectations of inflation rolling off in the second half, central banks have maintained a prudent stance, reducing the risk of premature easing. While noting that foreign exchange (FX) tends to be highly macro-driven, we see tactical value in select EM currencies with favorable fundamental traits. The moderating trend in price pressures is supportive of EM local rates. Finally, balance sheet strength of EM corporates will continue to underpin asset prices. Risks to the sector are primarily sovereign-driven (e.g., regulatory changes and geopolitical headwinds). We look for opportunities in the primary market to extract a new-issue premium in high-quality credits. EM corporates’ lower duration and volatility continue to represent an attractive risk/reward proposition.

Global Corporate Credit Sector Views


Auto & Related
Key Observations The global automotive market has experienced myriad challenges associated with the COVID-19 pandemic, including higher raw material input costs, semiconductor chip shortages, production delays, etc. We remain laser focused on OEMs, and suppliers’ ability to pass along higher costs to consumers and maintain their respective margin profiles, each companies’ liquidity position, and the impact of higher interest rates on demand levels, monthly payments and repossessions/delinquencies. Our primary concerns are associated with weaker consumer demand, ongoing US/China tension, weak profitability in Europe and uncertainties about the onset of a possible US recession later this year.
Energy
Key Observations Global oil prices retraced higher after the recent surprise OPEC+ supply cut amid lower demand expectations. Our view of range-bound prices over the short term remains, while natural gas weakness has largely been driven by mild winter weather. The uncertain economic backdrop continues to dampen refined product demand, balanced by continued energy industry capital discipline and OPEC supply management. Continued geopolitical tensions add further support to oil prices over the short term. Industry balance sheets are in strong shape, with management teams continuing to focus on shareholder return programs with the goal of rebuilding investor sentiment in the industry earning higher multiples relative to other income-generating industries. We continue to observe service cost inflation in the industry, reflective in higher year-over-year (YoY) capital budgets. M&A has been active recently, driven by low valuations relative to cash flow and the need to replace growth through basin consolidation or regional diversification. While companies are allocating resources toward renewables, we continue to believe fossil fuels and refined products will continue to play a large role in the future energy mix.
Food & Beverage
Key Observations The food and beverage industry is characterized by low elasticity. As a result, over the last few quarters most food and beverage companies have successfully raised prices in order to offset higher commodity input and labor costs. Consumer spending remains cautious, although spending has shifted to non-discretionary categories, such as food and beverage, which is a relatively recession-resilient category. This year declining freight rates should be a source of inflation relief despite supply-chain challenges that have not returned to pre-Covid levels. Food and beverage companies started the year on solid financial ground as free cash flow has predominantly been used to pay down debt, but dividends and share buyback programs are expected to accelerate this year.
Gaming
Key Observations We are monitoring the Macau market very closely, as the region’s integrated resorts reopened in early January, following President Xi’s relaxation of travel prohibitions throughout China. Since the reopening began, we have received a number of data points suggesting a sizable amount of pent-up demand from within mainland China, particularly during the recent Golden Week period in February. These trends have continued throughout March, and we believe the balance of FYE 2023 will provide validation for our long-standing viewpoint that Macau and Singapore have enormous earnings and free cash flow generation capabilities in a normal operating environment.
Health Care
Key Observations We continue to recommend underweighting IG health care and pharma due to a cyclical and secular decline in credit quality, rich valuations and negative event risks. We still prefer payors (i.e., health care insurers) over providers (i.e., health care service providers and pharma). We believe that health care/pharma, unlike other defensive sectors, can provide optionality outside of an economic cycle through its product-driven catalysts. In HY, we’ve seen notable dispersion across the health care sector, with hospitals showing notable weakness due to higher labor costs and lower acuity volumes (non-COVID-19 volumes did not rebound this quarter). Labor inflation will remain a headwind this year; we do expect to see moderate improvement across the sector in terms of labor rates but higher reimbursement rates may not be enough to offset cost pressures. In terms of volumes, we expect to see improvement in 2023, with activity expected to reach or exceed pre-pandemic levels.
Metals & Mining
Key Observations Metals markets continue to find support despite the prospect of recession; economic uncertainty, strained geopolitical tensions and a stronger US dollar all work against the space. The China reopening is slower than the market anticipated but is reopening nonetheless. Demand is expected to build in a more measured manner over the shorter term. We continue to believe the medium- to long-term outlook is supportive of higher future prices particularly in energy transition metals as the world collectively adopts policies to reduce fossil fuel consumption. We continue to watch the supply side constraints as the industry has underinvested (and continues to underinvest) for several years as conservatism in capital allocation prevails; balance sheet and liquidity preservation also prevail. With the large capital projects nearing conclusion and coming on line, free cash flow is expected to grow; the excess free cash flows are anticipated to bolster shareholder returns and potentially drive M&A; the latter is expected to be conducted in a prudent manner. Consequently, organic growth is likely to slow and the confluence of demand and supply should serve to tighten the future balances and support higher future prices. We continue to believe the industry remains much better positioned now for any downcycle and should be able to position for a stronger recovery in an upcycle.
Pharmaceuticals
Key Observations In the IG space, we recommend underweighting pharma. However, we are still selectively constructive on pharma companies that have a strong, young product pipeline with high-efficacy drugs whose growth is driven by higher volumes versus price increases. The near-term focus for HY pharma will be more idiosyncratic events specific to these credits (i.e., opioid litigation trials, patent challenges, spin-off transactions, etc.). We anticipate stabilization in the rate of generic price deflation and see potential for rising-star activity over the next couple of years.
Retailing
Key Observations Consumers in the US have relatively healthy balance sheets with relatively low leverage and a decent cash cushion, although demand for discretionary items remains uneven. During the first quarter, persistent and elevated inflation, as well as unfavorable weather and the banking crisis, were headwinds that are not expected to repeat during the second quarter. Last quarter, management teams spoke conservatively about the first half of the year as consumers continued to shift their spending priorities to more experiential retail, although management teams sounded relatively confident about the second half margin recovery thanks to lower operating costs, including the normalization of freight rates. Retailers have also scaled back inventory orders to better match lower demand and this should result in fewer markdowns and, ultimately, better margins.
Telecommunications & Media
Key Observations US domestic telecoms are facing increased scrutiny over capital intensity and return on investment. Wireless providers in particular are dealing with investor frustration over the cost of securing spectrum licenses versus the incremental revenue generated through new services. Domestic wireline business has been very weak with double-digit declines in enterprise revenue being very common. In Europe, there are similar, longstanding investor concerns, mostly around sector growth sustainability, probably justified given the historically underwhelming returns on equity. From a bondholder standpoint, however, what matters more in our view is the defensive nature of the telecoms business relative to other industrial sectors as well as the ongoing wave of non-core infrastructure asset monetization ranging from towers to fiber networks. We think that recent asset sale valuation multiples have generally been attractive. The proceeds are often earmarked for debt reduction and balance sheet repair in what remains a BBB sector, leaving us fundamentally constructive.
Transportation
Key Observations In the US, domestic leisure traffic remains robust and international demand is rapidly returning to pre-pandemic volumes in a strong fare environment. Per TSA throughput data, approximately 184.7 million passengers passed through US airport security during the first quarter of this year or roughly 99% of 2019 levels of 186.7 million passengers. However, revenues are almost 15% higher on a year-over-year basis given the numerous constraints across the aviation ecosystem combined with a decent macro backdrop. The solid outlook is being tempered by elevated fuel prices and the recent rise in labor compensation as a result of new pilot contracts. In addition, capacity remains tight due to ongoing delays of new aircraft deliveries by the OEMs, who continue to suffer from supply-chain issues and labor shortages. Despite these challenges, the industry is expected to generate robust free cash flow in 2023. Given the current financing environment, management teams are expected to maintain relatively high levels of liquidity and focus on deleveraging balance sheets.
Utilities
Key Observations The industry is weaker from a credit perspective compared with prior cycles; it is rated squarely in BBB territory and no longer the A/AA industry it once was. It is hard to see this changing with ever increasing capital budgets, which should continue to grow through 2024 (and are expected to grow beyond 2024). Electric utility companies continue to invest in regulated transmission and renewable generation as the energy transition accelerates and regulator-mandated portfolio standards/environmental compliance (which does not add capacity) continue to evolve. The regulatory and political environment is becoming more onerous in our view. The regulated allowable returns are coming down (partially offset by more timely recovery mechanisms) and the focus on protecting customers from rate increases, potentially pushing back on “prudently incurred costs” that would be reimbursed through rates. Management teams have become more focused on shareholder returns and conducting themselves in a more aggressive manner when it comes to funding and limiting equity issuance; managing closer to rating agency downgrade thresholds. This aggressiveness does not allow for any missteps in strategy execution.

Industry	Key Observations
Auto & Related	The global automotive market has experienced myriad challenges associated with the COVID-19 pandemic, including higher raw material input costs, semiconductor chip shortages, production delays, etc. We remain laser focused on OEMs, and suppliers’ ability to pass along higher costs to consumers and maintain their respective margin profiles, each companies’ liquidity position, and the impact of higher interest rates on demand levels, monthly payments and repossessions/delinquencies. Our primary concerns are associated with weaker consumer demand, ongoing US/China tension, weak profitability in Europe and uncertainties about the onset of a possible US recession later this year.
Energy	Global oil prices retraced higher after the recent surprise OPEC+ supply cut amid lower demand expectations. Our view of range-bound prices over the short term remains, while natural gas weakness has largely been driven by mild winter weather. The uncertain economic backdrop continues to dampen refined product demand, balanced by continued energy industry capital discipline and OPEC supply management. Continued geopolitical tensions add further support to oil prices over the short term. Industry balance sheets are in strong shape, with management teams continuing to focus on shareholder return programs with the goal of rebuilding investor sentiment in the industry earning higher multiples relative to other income-generating industries. We continue to observe service cost inflation in the industry, reflective in higher year-over-year (YoY) capital budgets. M&A has been active recently, driven by low valuations relative to cash flow and the need to replace growth through basin consolidation or regional diversification. While companies are allocating resources toward renewables, we continue to believe fossil fuels and refined products will continue to play a large role in the future energy mix.
Food & Beverage	The food and beverage industry is characterized by low elasticity. As a result, over the last few quarters most food and beverage companies have successfully raised prices in order to offset higher commodity input and labor costs. Consumer spending remains cautious, although spending has shifted to non-discretionary categories, such as food and beverage, which is a relatively recession-resilient category. This year declining freight rates should be a source of inflation relief despite supply-chain challenges that have not returned to pre-Covid levels. Food and beverage companies started the year on solid financial ground as free cash flow has predominantly been used to pay down debt, but dividends and share buyback programs are expected to accelerate this year.
Gaming	We are monitoring the Macau market very closely, as the region’s integrated resorts reopened in early January, following President Xi’s relaxation of travel prohibitions throughout China. Since the reopening began, we have received a number of data points suggesting a sizable amount of pent-up demand from within mainland China, particularly during the recent Golden Week period in February. These trends have continued throughout March, and we believe the balance of FYE 2023 will provide validation for our long-standing viewpoint that Macau and Singapore have enormous earnings and free cash flow generation capabilities in a normal operating environment.
Health Care	We continue to recommend underweighting IG health care and pharma due to a cyclical and secular decline in credit quality, rich valuations and negative event risks. We still prefer payors (i.e., health care insurers) over providers (i.e., health care service providers and pharma). We believe that health care/pharma, unlike other defensive sectors, can provide optionality outside of an economic cycle through its product-driven catalysts. In HY, we’ve seen notable dispersion across the health care sector, with hospitals showing notable weakness due to higher labor costs and lower acuity volumes (non-COVID-19 volumes did not rebound this quarter). Labor inflation will remain a headwind this year; we do expect to see moderate improvement across the sector in terms of labor rates but higher reimbursement rates may not be enough to offset cost pressures. In terms of volumes, we expect to see improvement in 2023, with activity expected to reach or exceed pre-pandemic levels.
Metals & Mining	Metals markets continue to find support despite the prospect of recession; economic uncertainty, strained geopolitical tensions and a stronger US dollar all work against the space. The China reopening is slower than the market anticipated but is reopening nonetheless. Demand is expected to build in a more measured manner over the shorter term. We continue to believe the medium- to long-term outlook is supportive of higher future prices particularly in energy transition metals as the world collectively adopts policies to reduce fossil fuel consumption. We continue to watch the supply side constraints as the industry has underinvested (and continues to underinvest) for several years as conservatism in capital allocation prevails; balance sheet and liquidity preservation also prevail. With the large capital projects nearing conclusion and coming on line, free cash flow is expected to grow; the excess free cash flows are anticipated to bolster shareholder returns and potentially drive M&A; the latter is expected to be conducted in a prudent manner. Consequently, organic growth is likely to slow and the confluence of demand and supply should serve to tighten the future balances and support higher future prices. We continue to believe the industry remains much better positioned now for any downcycle and should be able to position for a stronger recovery in an upcycle.
Pharmaceuticals	In the IG space, we recommend underweighting pharma. However, we are still selectively constructive on pharma companies that have a strong, young product pipeline with high-efficacy drugs whose growth is driven by higher volumes versus price increases. The near-term focus for HY pharma will be more idiosyncratic events specific to these credits (i.e., opioid litigation trials, patent challenges, spin-off transactions, etc.). We anticipate stabilization in the rate of generic price deflation and see potential for rising-star activity over the next couple of years.
Retailing	Consumers in the US have relatively healthy balance sheets with relatively low leverage and a decent cash cushion, although demand for discretionary items remains uneven. During the first quarter, persistent and elevated inflation, as well as unfavorable weather and the banking crisis, were headwinds that are not expected to repeat during the second quarter. Last quarter, management teams spoke conservatively about the first half of the year as consumers continued to shift their spending priorities to more experiential retail, although management teams sounded relatively confident about the second half margin recovery thanks to lower operating costs, including the normalization of freight rates. Retailers have also scaled back inventory orders to better match lower demand and this should result in fewer markdowns and, ultimately, better margins.
Telecommunications & Media	US domestic telecoms are facing increased scrutiny over capital intensity and return on investment. Wireless providers in particular are dealing with investor frustration over the cost of securing spectrum licenses versus the incremental revenue generated through new services. Domestic wireline business has been very weak with double-digit declines in enterprise revenue being very common. In Europe, there are similar, longstanding investor concerns, mostly around sector growth sustainability, probably justified given the historically underwhelming returns on equity. From a bondholder standpoint, however, what matters more in our view is the defensive nature of the telecoms business relative to other industrial sectors as well as the ongoing wave of non-core infrastructure asset monetization ranging from towers to fiber networks. We think that recent asset sale valuation multiples have generally been attractive. The proceeds are often earmarked for debt reduction and balance sheet repair in what remains a BBB sector, leaving us fundamentally constructive.
Transportation	In the US, domestic leisure traffic remains robust and international demand is rapidly returning to pre-pandemic volumes in a strong fare environment. Per TSA throughput data, approximately 184.7 million passengers passed through US airport security during the first quarter of this year or roughly 99% of 2019 levels of 186.7 million passengers. However, revenues are almost 15% higher on a year-over-year basis given the numerous constraints across the aviation ecosystem combined with a decent macro backdrop. The solid outlook is being tempered by elevated fuel prices and the recent rise in labor compensation as a result of new pilot contracts. In addition, capacity remains tight due to ongoing delays of new aircraft deliveries by the OEMs, who continue to suffer from supply-chain issues and labor shortages. Despite these challenges, the industry is expected to generate robust free cash flow in 2023. Given the current financing environment, management teams are expected to maintain relatively high levels of liquidity and focus on deleveraging balance sheets.
Utilities	The industry is weaker from a credit perspective compared with prior cycles; it is rated squarely in BBB territory and no longer the A/AA industry it once was. It is hard to see this changing with ever increasing capital budgets, which should continue to grow through 2024 (and are expected to grow beyond 2024). Electric utility companies continue to invest in regulated transmission and renewable generation as the energy transition accelerates and regulator-mandated portfolio standards/environmental compliance (which does not add capacity) continue to evolve. The regulatory and political environment is becoming more onerous in our view. The regulated allowable returns are coming down (partially offset by more timely recovery mechanisms) and the focus on protecting customers from rate increases, potentially pushing back on “prudently incurred costs” that would be reimbursed through rates. Management teams have become more focused on shareholder returns and conducting themselves in a more aggressive manner when it comes to funding and limiting equity issuance; managing closer to rating agency downgrade thresholds. This aggressiveness does not allow for any missteps in strategy execution.