Goldman Sachs' credit strategy team has issued an unusually pessimistic warning, stating that stress in capital markets is far from over. The team titled its latest report "The More We Think, The More Pessimistic We Become."
Amid persistent energy price shocks, elevated financing costs, and still-tight credit spreads, the team maintains a significantly underweight stance. They specifically identified AT1 bonds, investment-grade corporate hybrid debt, and BB-rated high-yield bonds as the next assets likely to face selling pressure.
The team, led by credit strategist Abel Elizalde, noted that their model portfolio is currently 78% underweight with a beta of -0.6. They believe the probability of ongoing energy price disruptions is increasing, creating a macroeconomic outlook that "does not look optimistic." At the same time, credit spreads remain tight relative to the current economic fundamentals. If fund outflows accelerate, market technicals could reverse quickly.
Regarding market impact, Goldman warned that while credit markets widened across the board last week, implied volatility lagged behind the CDS index. This suggests investors have heavily piled into more liquid macro hedging instruments. The team advised traders to begin selling credit volatility at current levels, arguing that markets are transitioning from a phase of rapid "shock-based" pricing to a slower "economic impact-based" pricing phase, though the overall directional view remains bearish.
**High Financing Costs Endanger Corporate Interest Coverage**
Goldman pointed out that corporate bond coupon rates have risen to decade highs. Since yields remain above coupon rates, financing costs are poised to climb further.
A more critical issue is that many companies planned their finances based on expectations of interest rate cuts. If the "higher for longer" rate scenario materializes, interest coverage ratios could fall into dangerous territory, forcing companies to take contractionary actions—reducing debt, cutting investment, and lowering costs.
The team estimates that, based on current economic and fundamental conditions, the fair value for the European crossover credit index (Xover) should be around 325 basis points, wider than current levels. If energy disruptions persist, worsening economic fundamentals would prevent any fair value compression. "This does not make us optimistic," the report stated.
**AT1s, Hybrids, BB-Rated Bonds: The Next "Shoe to Drop"**
Goldman listed AT1 bonds, investment-grade corporate hybrid debt, and BB-rated high-yield bonds as the prime candidates for the next wave of market stress.
The report noted that over the past two years, investors chasing beta returns heavily bought these assets, driving spreads to extremely tight levels. Due to their relatively higher liquidity, these assets would be the first to be sold off if market sentiment sours.
The team recommended shorting these assets and using underperforming segments of the iTraxx indices, such as senior mezzanine tranches, as hedges.
Specifically, investors long hybrid bonds could consider switching their exposure to the 6%-12% tranche of the iTraxx Main index. Those long BB-rated bonds or AT1s could shift to the 20%-35% tranche of the Xover index.
**Energy Shocks and Constrained Policy Complicate Macro Outlook**
Goldman believes the current geopolitical situation is more likely to escalate than de-escalate, increasing the risk of sustained high energy prices. Concurrently, European inflation break-even rates have jumped from 1.75% to around 3% within two weeks. This rapid repricing of inflation expectations has significantly narrowed central banks' policy options.
The report emphasized that current 10-year interest rates are substantially higher than when inflation initially surged in 2022. This greatly reduces the flexibility for coordinated monetary and fiscal policy responses.
If central banks hike rates too quickly to compensate for earlier misjudgments labeling inflation "transitory," it could significantly hurt economic growth. This might pressure governments to increase fiscal stimulus, potentially pushing long-term rates even higher and creating a vicious cycle.
"The more we think, the deeper we fall into the rabbit hole of pessimism," the report concluded.
Goldman said it will closely monitor money supply growth, bank lending rates, and net supply in credit markets to assess changes in private sector credit demand.
The team summarized that markets are shifting from pricing immediate shocks to pricing slower-moving economic damage, a process that will take more time to assess. "But this does not make us optimistic," they reiterated.