"More and more pessimistic"! Goldman Sachs: The "next shoe" in the credit market is dropping

Goldman Sachs' credit strategy team issued a rare pessimistic warning, stating that the current pressures in the capital markets have not yet been fully released, and directly titled their latest report "The More You Think, The More Pessimistic." Amid multiple pressures such as ongoing energy price shocks, high financing costs, and tight credit spreads, the team maintains a significantly underweight position, specifically naming AT1 bonds, investment-grade corporate hybrids, and BB-rated high-yield bonds as the next batch of assets likely to be sold off. Led by Goldman Sachs credit strategist Abel Elizalde, the team noted in their latest report that their model portfolio is currently at a 78% underweight status, with a beta of -0.6. The team believes that the probability of continued energy price disturbances is rising, and the resulting macro scenario is "not optimistic"; meanwhile, credit spreads remain tight relative to the current economic fundamentals, and if capital outflows accelerate, the technical situation could quickly reverse. In terms of market impact, Goldman Sachs warned that last week the credit market widened across the board, but the performance of implied volatility lagged behind the credit default swap index, indicating that investors have flocked to more liquid macro hedging tools. The team suggests that traders start selling credit volatility at current levels, reasoning that the market is transitioning from a "shock-driven" rapid pricing phase to a "economic impact-driven" slow pricing phase, but the outlook remains bearish. High Financing Costs, Corporate Interest Coverage at Risk Goldman Sachs pointed out that corporate bond coupon rates have risen to a ten-year high, and since yields are still above the coupons, financing costs are expected to rise further. The more critical issue is that companies have generally planned their finances based on expectations of interest rate cuts; if the scenario of "higher for longer" interest rates materializes, interest coverage ratios will fall into a dangerous range, forcing companies to take contractionary actions—reducing debt, cutting investments, and lowering costs. The team believes that based on the current economic and fundamental conditions, the fair value of the European cross-credit index (Xover) should be around 325 basis points, still wider than current levels. If energy disturbances continue, the economy and fundamentals will further deteriorate, and the fair value will not narrow, "this will not make us optimistic." AT1, Hybrid Bonds, BB-rated Bonds: The Next "Shoe" Goldman Sachs has listed AT1 bonds, investment-grade corporate hybrids, and BB-rated high-yield bonds as candidates for the "next shoe to drop." The report noted that over the past two years, investors have heavily bought these assets in pursuit of beta returns, leading to extremely tight spreads, and these assets have relatively ample liquidity; once market sentiment reverses, they will be the first to be sold off. The team recommends shorting these assets and using relatively underperforming varieties in the iTraxx index as hedging targets, such as senior mezzanine tranches. Specifically, investors holding long positions in hybrid bonds may consider shifting their positions to the iTraxx main index 6%-12% tranche; investors holding BB-rated bonds or long AT1 positions may shift to the Xover 20%-35% tranche. Energy Shocks Combined with Limited Policy Space, Macro Outlook Becomes Complex Goldman Sachs believes that the current geopolitical conflict is more likely to escalate rather than ease, and the persistent risk of high energy prices is rising. Meanwhile, the European inflation breakeven rate has jumped from 1.75% to about 3% within two weeks, and the rapid repricing of inflation expectations has significantly narrowed the policy options for central banks. The report particularly emphasizes that the current ten-year interest rate level is far higher than it was when inflation first emerged in 2022, making the coordinated response of monetary and fiscal policies much less flexible than expected. If the central bank raises interest rates too quickly to compensate for its previous misjudgment of "transitory inflation," it will have a significant impact on economic growth and may force the government to increase fiscal stimulus, thereby pushing up long-term rates and creating a vicious cycle. "The more you think about it, the more you will fall into a pessimistic rabbit hole," the report states. Goldman Sachs indicated that it will focus on tracking two indicators: the growth rate of money supply and bank credit, as well as the net supply in the credit market, to assess changes in private sector credit demand. The team concluded that the market is transitioning from a shock pricing phase to an economic impact pricing phase, which requires more time to assess actual economic damage, and the pace will be slower, "but this will not make us optimistic."