"The more I think about it, the more pessimistic I become"! Goldman Sachs: The credit market's "next shoe" is dropping

Goldman Sachs Credit Strategy Team Issues Rarely Pessimistic Warning, Saying Current Capital Market Pressures Are Far From Over, and Names Its Latest Report “The More You Think, The More Pessimistic.”

Amid ongoing energy price shocks, high financing costs, and tight credit spreads, the team maintains a significantly underweight stance, specifically pointing out AT1 bonds, investment-grade corporate hybrid bonds, and BB-rated high-yield bonds as the next assets likely to be sold off.

Led by Goldman Sachs credit strategist Abel Elizalde, the team states in its latest report that its model portfolio is currently 78% underweight, with a beta of -0.6. The team believes the probability of persistent energy price disruptions is rising, and the macro scenario derived from this “is not optimistic”; meanwhile, credit spreads remain relatively tight compared to current economic fundamentals, and if capital outflows accelerate, technical factors could quickly reverse.

Market Impact: Goldman Sachs warns that last week’s credit markets widened across the board, but implied volatility lagged behind the credit default swap index, indicating investors have heavily flooded into liquid macro-hedging instruments. The team recommends traders start selling credit volatility at current levels, reasoning that the market is transitioning from a “shock-based” rapid pricing phase to a “slow” pricing phase driven by “economic impact,” but the overall outlook remains bearish.

High Financing Costs, Corporate Interest Coverage at Risk

Goldman Sachs points out that corporate bond yields have risen to a ten-year high, and since yields still exceed coupon rates, financing costs are expected to climb further.

More critically, many companies previously based their financial planning on rate cuts; if the scenario of “higher for longer” interest rates materializes, interest coverage ratios will fall into dangerous territory, forcing companies to tighten—reducing debt, cutting investments, and lowering costs.

The team believes that, based on 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 disruptions persist, economic and fundamental conditions will worsen further, and fair value will not narrow, “which does not make us optimistic.”

AT1, Hybrid Bonds, BB-rated Bonds: The Next “Boots”

Goldman Sachs lists AT1 bonds, investment-grade corporate hybrids, and BB-rated high-yield bonds as candidates for the “next shoe” to drop.

The report notes that over the past two years, investors chasing beta returns have heavily bought these assets, leading to extremely tight spreads. These assets are relatively liquid, and once market sentiment reverses, they will be the first to be sold.

The team recommends shorting these assets and using relatively underperforming instruments in the iTraxx index as hedges, such as senior mezzanine tranches.

Specifically, investors holding long positions in hybrids might consider shifting their positions to the 6%-12% tranches of the iTraxx main index; those holding BB-rated bonds or AT1s could switch to the 20%-35% tranches of the Xover index.

Energy Shocks and Policy Space Constraints Make the Macro Outlook More Complex

Goldman Sachs believes that current geopolitical conflicts are more likely to escalate than ease, with ongoing risks of high energy prices. Meanwhile, European inflation breakeven rates have jumped from 1.75% to about 3% within two weeks, and the rapid repricing of inflation expectations has significantly narrowed central bank policy options.

The report emphasizes that current ten-year yields are well above levels at the start of 2022 when inflation first emerged, making monetary and fiscal policy coordination less flexible than expected.

If central banks overreact and raise rates too quickly to correct their previous “transient inflation” misjudgment, it could significantly impact economic growth and force governments to increase fiscal stimulus, pushing long-term rates higher and creating a vicious cycle.

“The more you think, the more you fall into a pessimistic rabbit hole,” the report states.

Goldman Sachs plans to closely monitor two indicators—money supply and bank credit growth, as well as net credit market supply—to assess changes in private sector credit demand.

The team concludes that the market is transitioning from shock pricing to economic impact pricing, which will take more time to assess actual economic damage. The pace will be slower, “but this will not make us optimistic.”

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