Debt Capital Markets
After a period of uncertainty during the pandemic, which resulted in one of the steepest drops in global GDP in history, the prognosis for 2022 is brighter and more affluent. According to JPMorgan analysts, 2022 will be a year of global recovery following the end of Covid 19-induced limitations and the return to normalcy (JPMorgan, 2022). With the return of mobility throughout the world and a rapid increase in consumer expenditure, including corporate spending, a cyclical rebound is envisaged.
The monetary policy stance, which was predicted to be accommodating in the first half of the year, is likely to shift to modestly assertive in the second half of the year. Rising inflation is going to be a persisting concern for multiple economies due to supply chain bottlenecks and expected to ease only in the latter half of the year because of targeted policy responses and decrease in supply demand imbalances (IMF, 2022). The Bank of England has raised rates to combat increasing prices (King, 2022), and the US Fed, European Central Bank, and Bank of Canada are all likely to follow suit, showing that the regulators' position has switched from dovish to slightly hawkish. The following graph depicts the rate of global GDP growth in comparison to financial crises and previous expansionary periods:
(JP Morgan, 2022)
The rebound of global output following the pandemic is likely to outperform both the recovery from the global financial crisis and the average of the previous three expansions. This scenario is predicted to come true as a result of the private sector's solid fundamentals and continued expansion. During the epidemic, people and corporations built up savings, which is likely to stimulate demand for worldwide services and inventory. An ideal formula for a global boom in the making is a mix of solid foundations and policies aimed at growth in all industries.
During the times of the pandemic the issuance of High yield bonds have gained prominence around the world. In the US, high yield or junk bonds represented 25 percent of the total bond issuances in the country as they were supported immensely by the debt market investors due to high returns associated with it. With an expected flattening of yield curve in the latter half of the year due to tightening of monetary policy by central banks, a shift of investment in investment grade corporate bonds along with some investment in high yield bond is anticipated (Michele, 2022).
Outperforming Industry in 2022
The following section highlights the performance of industries in the debt capital markets in the latter half of the year:
- Banks and financial – One of the most beneficial industry according to bond market expectation is the banks and financial institutions. A rising interest rate environment would propel growth in the industry as banks would be able borrow at lower rates and lend at higher rates. High yield bonds from banking and finance industry are expected to perform well due to low risk of default (Martin, 2022).
- Energy industry – On the back of rising energy prices around the globe, the industry is expected to perform well in the future periods to come. Amongst all other energy commodities, oil is expected to become the major beneficiary of the economic recovery with a rise in price per barrel.
- Basic materials – High infrastructural development that is expected generate pace may be able to push the valuations of basic materials companies to higher levels. With electronic market vehicle picking up around the world demand for charging infrastructural development would rise benefitting material companies. Miners of lithium, cobalt, and nickel would be benefitted due to a rise in demand of batteries for electronic vehicles (Fidelity, 2022).
- Real Estate – Rising interest rate environment across the world would be beneficial for real estate owners as due to the effect of inflation the rents for the properties would rise. The sector is historically been considered as an inflation hedge and is expected to outperform in a rising inflation environment (Rastegar, 2022).
- Retail industry – A rise in consumer sentiment would result in benefits for the retail industry. Companies are moving towards raising prices and improving upon the margins for superior performance. Operational changes like closing of unprofitable shops and reducing inventory levels have allowed some retail companies to withstand the negative effects of the pandemic (Deloitte, 2022).
The consequences of central banks tightening regulatory control and monetary policy varied depending on the industry. With rising interest rates but stable economic growth, particular industries may have lower default risk and lower interest rate risk. Financial sector which represents, banks, brokerage firms, insurance sector and other financial intermediaries (OECD, 2022), are most sensitive to interest rate fluctuations, doing extremely well in rising interest rate environments due to rise in profit margins for the companies.
A robust worldwide economic rebound is forecast, which would benefit the financial industry since a strong global economy means borrowers will have an easier time repaying their loans and banks will have fewer non-performing assets. The insurance industry has a linear connection with interest rate increases, with performance rising with each increase. The following section highlights the positives for the industry in the coming period:
- A rise in long- and short-term interest rates would boost the industry's growth while also boosting margins, and raise the amount of money distributed to investors in the form of dividends (Kastner, 2022).
- The current valuations in the industry is higher than the historical average and other sectors of the economy (Kastner, 2022).
- The reserves created to protect against loss on loans are released on the back of falling default rates across the globe due to improvement in the economic growth rates.
Consumer durables industry are goods which are for long term use and like cars and household appliances. The industry is mostly affected by inflation due to rise in input costs which is passed on to customers resulting in fall in revenues. The industry is expected to underperform under a rising interest rate environment.
In an environment where interest rates are expected to rise, the risk and return perception of investors tends to change. Preference for less volatile and stable investment vehicles rises during high interest rate environments.
Rising interest rates is a matter of concern for investors that have positions in bonds as a rise in interest rates would instigate a fall in the value of the bond. The fall in value of the bond is due to the fact that demand for bonds falls as other fixed income instruments like fixed deposits offer higher rate of interest. Longer term bonds are more sensitive by change in interest rates as a result the loss of capital is greater in longer term bonds compared to short term bonds.
Rise in interest rates may also prove to be detrimental for equity market as it can put brakes on the economic growth of the country. Although higher inflation indicates rise in economic growth, a rise in interest rates may limit the accessibility of credit for individuals and corporates resulting in fall in demand and economic withering. Corporates would find investment in projects difficult due to the rise in cost of capital and hence witness a fall in planned investment.
Underperforming Industry in 2022
Despite the negative effects of higher interest rates on economic development, banking and financial sector shares are likely to outperform the capital markets, since banks will be able to enhance their profit margins and non-performing assets will shrink as a result of economic growth.
Retail company shares would be the biggest winners, since higher profit margins would lead to better financial performance and a higher value owing to better future prospects. Due to rising property and rental prices, investing in tangible assets such as homes might produce huge rewards for investors. REITs can also be used as a vehicle for investing because of their scalability and expert management. Investment grade bonds issued by corporations in the mining and commodities sectors, combined with big cap equities issued by companies in the industry, can prove to be a beneficial strategy for capturing alpha.
Junk grade bonds are typically known to perform well in times of economic expansion where investors try to capture high yield on the back of falling default rates. In times of economic uncertainty and rising interest rates, high yield bonds of companies belonging to the consumer durable industry would be underperforming the market.
Investment grade corporate bonds, particularly those belonging to the financial sector, should be chosen as a vehicle of investment to capture the benefits of the predicted economic scenario, as the financial industry is the primary beneficiary of the increasing interest rate environment. Bonds from the non-financial sector that have higher ratings and longer maturities should be avoided since they are the most interest-sensitive vehicles. Bonds issued by companies undergoing mergers and acquisitions should be avoided because changes in capital structure may dilute bondholders' stakes, resulting in a drop in value. Specific industries, such as energy, retail products, and building materials, are predicted to fare well in the next economic climate. To achieve a high return, high yield bonds with ratings in the B to BB range should be carefully sought.
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