Morgan Stanley IM: The R.I.P. Cycle, Part 2: Credit Risk

Jim Caron, Portfolio Manager and Chief Fixed Income Strategist, shares his macro thematic views on key market drivers.

05.10.2022 | 08:20 Uhr

As we have discussed, Recession, Inflation and Policy risks form the R.I.P. Cycle. This is because Policy can either address Inflation or Recession risk - but not both simultaneously. This amplifies the risk that a policy mistake can have grave (R.I.P.) consequences.
The implication is that the Fed has to choose to fight inflation or recession risk. In this case, they are choosing to fight inflation, which increases recession risks.
The linkage to credit risk is important, as credit risk increases and is highly correlated with the depth and breadth of a recession. This gets priced in the credit markets as higher default risk, which causes spreads to widen.
The greater the number of rate hikes, and the greater the speed at which those hikes occur – both designed to lower inflation risks – well, the greater the risk of a deeper recession. The result is that default risks increase and spreads widen to price in a higher risk premia.
In the end, we still advocate a balanced portfolio with a bias toward high quality assets and an average duration of 3-4 years.

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See below for important disclosures.

Risk Considerations

Diversification does not eliminate risk of loss. There is no assurance that a portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the portfolio will decline and that the value of portfolio shares may therefore be less than what you paid for them. Market values can change daily due to economic and other events (e.g. natural disasters, health crises, terrorism, conflicts and social unrest) that affect markets, countries, companies or governments. It is difficult to predict the timing, duration, and potential adverse effects (e.g. portfolio liquidity) of events. Accordingly, you can lose money investing in this portfolio. Please be aware that this portfolio may be subject to certain additional risks. Fixed income securities are subject to the ability of an issuer to make timely principal and interest payments (credit risk), changes in interest rates (interest-rate risk), the creditworthiness of the issuer and general market liquidity (market risk). In a rising interest-rate environment, bond prices may fall and may result in periods of volatility and increased portfolio redemptions. In a declining interest-rate environment, the portfolio may generate less income. Longer-term securities may be more sensitive to interest rate changes. Mortgage- and asset-backed securities are sensitive to early prepayment risk and a higher risk of default, and may be hard to value and difficult to sell (liquidity risk). They are also subject to credit, market and interest rate risks. Certain U.S. government securities purchased by the Strategy, such as those issued by Fannie Mae and Freddie Mac, are not backed by the full faith and credit of the U.S. It is possible that these issuers will not have the funds to meet their payment obligations in the future. High-yield securities (“junk bonds”) are lower-rated securities that may have a higher degree of credit and liquidity risk. Public bank loans are subject to liquidity risk and the credit risks of lower-rated securities. Foreign securities are subject to currency, political, economic and market risks. The risks of investing emerging market countries are greater than risks associated with investments in foreign developed countries. Sovereign debt securities are subject to default risk. Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Restricted and illiquid securities may be more difficult to sell and value than publicly traded securities (liquidity risk).