The current correction across financial markets is exceptional: It is indeed hitting most asset classes hard, but, this year, high-quality government bonds and investment-grade credit have seen their worst-case scenarios to date. Meanwhile, equities and high-yield bonds have seen comparable losses in total return terms, but are still a long way from their previous maximum drawdowns (e.g. during the financial crisis). This development can be attributed to the prevailing high inflation and, correspondingly, decisive response by central banks to combat spiralling prices, which is being undertaken by strong and rapid increases in interest rates. High-quality bonds, which are highly sensitive to interest rate movements, have therefore suffered the most. In the meantime, the record-pace rise in real interest rates since the fourth quarter of 2021 is having the desired effect: Long-term inflation expectations derived from inflation-linked bonds are trending downwards, particularly in the US. Supply chains are also easing and, according to surveys, consumers’ inflation expectations, in the US for example, are also falling.
With its decisive action, the Fed has achieved first successes and, for the time being, has also managed to maintain its credibility. However, the price of success is high, as it could push the US economy into recession. Any recession, however, is likely to be less severe than in Europe, where the economy is being more greatly impacted by high energy prices, while domestic consumption acts as less of a shock absorber than in the US. In this context, current equity valuations are still too high as corporate earnings are likely to come under significant pressure in the months to come. We therefore see additional potential for equity market losses due to a possible combination of negative factors, which could act as a double whammy. First, earnings expectations, which are currently still quite robust, could see further downward revisions or the market could be surprised by disappointing corporate results. Second, given negative market sentiment and rising risk premiums, earnings-based multiples may also decrease. Conversely, for high-quality bonds, where risk premiums are less sensitive to corporate results, the worst is likely over in our view.
Interestingly, defensive investment grade (IG) corporate bonds are currently compensating for the risk far better than equities are. This becomes evident, for example, when comparing yields: The yield on US IG corporates currently stands at 5.5 per cent, equal to the S&P 500 earnings yield, which includes dividends as well as retained earnings and puts them in relation to the share price. This situation of these very different asset classes providing the same yields was last seen at the height of the financial crisis, when corporate earnings fell sharply on the back of the recession. In our view, this opens up a particularly attractive opportunity as investors can choose a more defensive investment without sacrificing much yield. IG credit also looks favourable relative to high yield as heavy new issuance has caused IG spreads to widen significantly more than the typical relationship to high yield would imply.
Fundamentals of US IG corporates are very solid, and they appear well equipped to deal with the expected macroeconomic headwinds. Revenues, profits and margins have grown significantly in recent years and are now serving as a buffer against increasing input costs from elevated commodity prices and rising wage costs. In addition, debt ratios and liquidity are generally stable. This is reflected in a positive rating momentum, where we are seeing 2.5 upgrades for every downgrade. In our view, the IG asset class can weather the recession relatively well due to the high quality of the borrowers, whose credit premiums are therefore much less sensitive. Conversely, we see more fundamental risks for European IG issuers. For example, debt ratios are rising, while profit margins are falling, especially when excluding the exceptionally strong energy sector. However, as a result of this discrepancy, US bonds are also more expensive. Considering also the elevated US Dollar currency hedging costs for Euro-based investors, we view spreads and yields in the EUR IG corporates market as cheap. For this reason, we currently identify EUR bonds issued by US debtors (known as Reverse Yankees) as being in a sweet spot, since this is where we are currently finding ‘the best of both worlds’ – solid fundamentals and, at the same time, compelling risk premiums.
At the sector level, we are currently favouring financials, which have significantly underperformed non-financials year to date. At almost 40 basis points, the additional premium compared to industrials is unusually high. Bank fundamentals appear solid, as profitability improves with rising interest rates as long as yield curves remain steep. In addition, both their credit quality and capital base are stronger than they were pre-pandemic, and stress tests in recent years have shown that European banks, in particular, have become more resilient. In addition, the banking sector within the IG fixed-income universe by nature has a shorter duration, which reduces interest rate sensitivity. Therefore, overweighting the sector makes sense to us at this time.
Overall, we are seeing a number of attractive opportunities within high-quality corporate bonds after this year’s significant correction. And, when the long-awaited central bank policy pivot takes place, we expect IG bonds to strongly benefit from falling rates, by virtue of their long duration.