We’ve got the (pricing) power

After four decades of strong growth and muted inflation, we have now entered an environment akin to that of the 1970s stagflation era. With inflation expected to impact revenue and margins, we believe that those companies with inelastic demand and an ability to pass on costs (i.e. those with good pricing power) are best positioned to withstand the current environment.  

The risk of default has increased for private credit investors as a result of the impact on corporate profits from higher costs and thus borrower debt servicing capacity. Using public bond data, we’ve sought to better understand the relationship between pricing power and default risk.

In our latest mid-year outlook on private credit, we’ve retained a strong bias to defensive issuers, given recent market volatility. Specifically, around two-thirds of our private credit borrowers are in sectors considered to have good, or average, pricing power.

Better pricing power, lower default risk?

Based on data from Moody’s, we analysed a wide range of sectors, ranking their respective default rates for each year between 1970 and 2021. At the same time, we considered each sector’s pricing power based on external research and our own views.

Our analysis suggests that sectors with weaker pricing power generally experienced higher default rates. This is particularly acute in sectors related to discretionary spending, such as leisure, media, non-durable consumer goods and retail. Construction and building and metals and mining also performed poorly despite their relatively higher pricing power, likely due to the cyclicality of the sectors.

We also noticed that default performance over a long time horizon is not always consistent. Some sectors performed better in the 70s, 80s and 90s (e.g. retail) while the technology sector has seen much lower defaults in the past 20 years than the preceding decades. This is likely driven by the fact that a sector’s pricing power changes over time as the market evolves with regulation, demographics and technology.

Impact on market value

We repeated the analysis with credit spreads, using sector-specific US investment grade credit indices, which have data going back to 1997. Interestingly, long-term pricing power didn’t seem to have a clear correlation with credit spread movement. However, during times of market stress, pricing power appeared to provide additional defensiveness.

For example, spreads widened significantly during the market volatility of 2000, 2007, 2008 and 2015. The best-performing sectors during those years included aerospace and defence, food and beverage, and pharmaceuticals, all of which possess strong pricing power.

For investors concerned about the market value of their fixed income assets, particularly during the turbulent times we’ve seen recently, we believe pricing power is a useful tool to dampen volatility and reduce default risk.