Default outlook weaker but manageable Relative value favours European credit Default expectations for HY have evolved through 2022, from The severe energy shock in Europe on the back of Russia’s quite benign at the beginning, to somewhat worse than the invasion of Ukraine has brought about recession risks which have historical average currently. Most of the deterioration came been promptly reflected in the relative pricing of European credit through the summer, as yields and cross-asset risk premia rose premia compared to other geographies. Once we normalise yields notably. Key default predictors have deteriorated, such as bank for duration mismatch (the US benchmark is much longer than lending standards (green line, Exhibit 27). The same is true for the European one) and deduct currency hedging costs, euro credit predictors that comprise interest rate risk – the refinancing shows a significant yield pickup over dollar credit (Exhibit 29) – gap, the difference between average yield and average coupon near its historic highs in IG, at just under 2%, and at its highest of an index and price-based bond distress ratios (orange line, level since the Eurozone debt crisis in HY, at circa 3.5%. Exhibit 27). By contrast, spread-based bond distress ratios have remained reasonably well contained (blue line, Exhibit 27). Exhibit 29: Adjusted for duration and currency hedging costs, euro credit offers historically high yield pickup over dollar credit Exhibit 27: Default predictors have deteriorated, particularly Yield, FX adjusted & 4y duration equivalent those with interest rate risk like the price-based distress ratio 10 Typical default predictors for USD HY 8 EUR IG - USD IG 1.82 100% Distress ratio, spread > 1000bp EUR HY - USD HY 3.53 6 80 Distress ratio, price < 80c 4 60 Bank lending constraint 2 40 0 20 -2 0 -4 -20 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 Source: Bloomberg, ICE and AXA IM Research, 21 November 2022 -40 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022 To establish relative value in terms of credit risk in isolation Source: US Fed, ICE and AXA IM Research, 21 November 2022 (spreads rather than yields) and across markets, we can compare The deterioration of default predictors has pushed model- excess spreads, namely nominal spreads minus credit losses. forecast default rates higher, to levels that are above spread- Credit losses are due to defaults in HY and ‘fallen angels’ – implied defaults at current spread levels. This has made default companies downgraded from IG to HY. Default predictors inform valuations no longer cheap, across most HY credit cohorts. This us about default expectations over the next 12 months, while the direction in Purchasing Managers’ Indices indicate fallen is the case for the Moody’s HY cohorts for US and Europe angel expectations. Normalising excess spreads as a deviation (Exhibit 28) as well as the ICE benchmark for US dollar HY. The one exception is the ICE euro HY benchmark that still looks from their historic mean gives the relative value ‘pecking order’ cheap, in our view, by around 100bps. (Exhibit 30). US dollar HY appears rich while euro IG look cheapest, followed by sterling IG, euro HY and dollar IG. Exhibit 28: Default forecasts have risen, making valuations no longer cheap, across most high yield credit cohorts Exhibit 30: Excess spread across investment grade and high Moody's annual HY default rate spread yield flags the relative value in European over US credit implied 16% 8x Excess spread (4y dur equiv) abs Z-score US 1.5% defaults 14% Fwd estim USD IG 0.67 5 EU 2.2% now below 4 US fcast 4.8% forecasts 12% EUR IG 2.26 GBP IG 1.47 EU fcast 3.9% 10% USD HY -1.09 EUR HY 1.09 3 AXAIM fcast 8.1% 2 Sprd impld 8% 7x 1 5.6% 5.9% 6% 0 4.9% 4% -1 2% -2 0% 6x -3 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023 -4 Source: Moody's, ICE, Fed, ECB and AXA IM Research, 21 nov 2022 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Source: Fed, ECB, ICE and AXA IM Research, 21 November 2022 26