The resilient allure of IG corporates amid economic challenges and rates volatility

The US yield curve has kept investors on their toes over the last few years. The relentless rise in Treasury yields on the back of policy rate hikes produced significant losses for fixed income investors, particularly in 2022. Moreover, investors grappled with heightened volatility in interest rates reflective of the uncertainty surrounding the inflation and economic growth outlook and the monetary policy path of central banks. This year, US Treasury yields continued to move higher as inflation proved to be stickier than expected, while underlying economic conditions remain surprisingly strong well into the rate hiking cycle. Although central banks remain in tightening mode, expected returns from fixed income investments have improved substantially, offering a compelling argument for investors to reassess the risk/return trade-off of owning bonds, especially as we approach the end of the rate-hiking cycle.

The US yield curve in flux
Treasury yields dipped temporarily following the banking sector turmoil in March as flight-to-safety investor flows pushed the 10-year yield to a year-to-date low of 3.3%. The improving growth optimism over the summer months subsequently pushed yields higher. The Fed policy meeting on 20th September accelerated the move higher given that the upward revisions to their policy rate projections strengthened the “higher for longer” narrative. Despite a few negative external factors, the 10-year yield breached 5.0% in October and the yield curve steepened as short-term yields, which are more sensitive to central bank actions, remained range-bound. Although we have seen some unwinding of these moves in November, we expect further steepening of the yield curve, given increased Treasury issuance needs to finance the rising US debt, combined with the Fed reducing its balance sheet size through quantitative tightening. At this stage of the economic cycle, a sustained rally in Treasuries would need to be front-end driven on the back of a pivot in monetary policy. However, given that there are no clear recessionary signs in the US economy yet, and core inflation components remain strong, this hypothesis seems unlikely for now.

High grade corporates better positioned for high rates and slowing growth
We are seeing that the more restrictive monetary policy is starting to work, particularly the slowing credit creation and more expensive financing terms becoming a key risk factor for businesses. Higher financing costs are delaying or slowing down business investment while profitability is expected to decline given pressures on margins. Having said that, this comes after a period of easy monetary policy and strong business conditions during which companies had been able to refinance at low rates and benefited from boosted revenues and profit margins well beyond pre-pandemic levels. As a result, companies today are in a far stronger position to withstand a period of economic weakness despite the negative fundamental trajectory. Against this backdrop, investment grade (IG) corporate bonds should fare better as the increase in funding costs is more manageable for IG issuers given lower overall debt levels. Looking at credit risk premia in the corporate bond universe, IG spreads, particularly in developed markets, appear fairly valued. While there is scope for spreads to widen further on the back of macroeconomic uncertainty, high-quality corporate bonds continue to benefit from strong technical tailwinds: On the supply side, new bond issuance is expected to decline sharply in the fourth quarter of 2023, while at the same time we are seeing persistently strong demand for high quality corporate bonds. Unlike before, demand is also less sensitive to episodes of negative rate moves as investors are enticed by the high all-in yield levels. Therefore, any decisive move wider in credit spreads will likely be met by strong demand, capping the extent of widening.

The impact of higher interest rates is likely to be more pronounced in leveraged issuers. High yield corporates are seeing larger incremental costs on funding and refinancing, particularly in the lowest-rated segments. As a result, the risk of rating downgrades is increasing, namely in the lower single-B rated bonds. Moreover, the very benign environment of low default rates is likely behind us, and are projected to normalise back toward long-term averages over the next year. However, with the recent widening in high yield spreads more adequately reflecting these downside risks, the rationale for owning sub-investment grade credit in a fixed income portfolio remains intact. The overall quality of the high yield corporate bond market has increased over the last several years with the improved underlying rating composition. Moreover, debt ratios today are still relatively low in anticipation of these headwinds. Nevertheless, investors should be mindful of the growing pressure in credit conditions, with the implication that individual company selection is becoming ever more important.

In summary, a preference for IG corporates should remain at this stage of the economic and interest rate cycle. With yields at the higher end of the long-term range, investors have a sizeable cushion in expected carry returns against further rates volatility. The risk of losses from potentially widening credit premia can be mitigated through a high-quality bias in a well-diversified portfolio. In addition, US dollar hedging costs have gradually declined, as other central banks caught up with the Fed in the hiking cycle. This, together with the re-steepening of the US yield curve, has increased the attractiveness of USD-denominated bonds for European investors. Lastly, the asset class should benefit from strong tailwinds once central banks eventually signal a definitive move towards lowering policy rates.

Chart: Improved attractiveness of USD IG corporate bonds for European investors as hedge costs decline

^{Source: Bloomberg, Fisch Asset Management}