Yields on corporate bonds with an investment grade (IG) rating have quadrupled in just 15 months. This is due not only to the turnaround in interest rates but also to the turmoil in risk premia, which are now well above their long-term average once again in light of the uncertainty in the Ukraine conflict. Given the fundamental and technical state of the market, we believe an interesting entry opportunity is emerging.
The currency-hedged yield in euro of the Barclays Global Agg Corporate index fell to around 0.5% at the end of the pandemic year 2020. In 2021, the prospect of upcoming monetary policy tightening led to an increase in yields to 1.2% as at the end of December. Only two-and-a-half months later, the yield stands at 2.0%. The IG Corporate index is down -7.5% for the year to-date (as at 16 March). Although the rise in interest rates does account for around two-thirds of this, it is surprising that the loss was greater than in the high yield market (-6%), even if we disregard the interest rate effect in both markets. Indeed, the risk premia of IG corporate bonds have reacted much more strongly than one would expect relative to other segments of the credit market.
According to J.P. Morgan, IG spreads currently reflect a probability of recession of around 50%, and thus paint a much more pessimistic picture than the high yield segment, at only around 20-30%. Thus, in our view, IG spreads have reached a level that make the risk/reward ratio look much more positive for IG investors.
In particular, we are encouraged by IG companies’ strong fundamental position. Especially at a time when commodities prices are rising globally, companies need solid margins and/or a strong market position to maintain credit quality. The IG segment offers a wide selection of companies that, on the basis of their market position and pricing power, could even survive the hard times, which may well lie ahead over the coming years, and remain in good shape. The coronavirus crisis – which has only just been overcome – was a superb test of these companies’ resilience.
It is possible that IG bonds also came under pressure because of the high liquidity they offer, for instance relative to the high yield segment, and became victims so to speak of their own good quality. Their high liquidity nonetheless remains a positive feature of these bonds, as opportunities cannot be dynamically and actively exploited in the absence of market liquidity.
In terms of market technicals, IG bonds should get a boost from purchases by large institutional investors. Rising yields strongly improve the funding ratio of pension funds. By rotating out of equities and into bonds, for instance, these higher yields can be locked in for the longer term. Pension funds have a broad positioning in the bond market, but the majority of the allocation goes into high-quality and liquid instruments, both features that IG corporate bonds offer.
In the current situation, which is still overshadowed by serious geopolitical and economic risks, we are positioned primarily in bonds from overseas, especially those of North American issuers. Here we prefer the energy and media sectors, which are currently benefiting from strong fundamentals and attractive valuations. We are cautious on sectors that are likely to be impacted by rising commodity prices or rising interest rates in the future, such as transport, electricity suppliers and the real estate sector. However, we continually analyse and monitor the full sectoral spectrum to see whether we can identify instruments that have suffered unjustified corrections or have become undervalued – as often happens in times of crisis. But with experience showing that such distortions do not last long and are also regarded as attractive by other market participants, swift and dynamic decision-making is pivotal in the prevailing environment.