Among bond markets, investment grade corporates were hit harder during the recent months’ market swoon than most other segments and have even underperformed numerous equity markets. But now the tide is turning as investors progressively refocus their attention on IG bonds. For, when a potential recession is increasingly being priced in by market participants, high-grade bonds that are fairly valued offer better protection than lower-rated bonds and equities.
In the meantime, the omnipresent theme of inflation has been mostly priced into spreads. Investors are hardly surprised anymore by how high and persistent inflation has become. And they are assuming a hawkish reaction from central banks in the months ahead. Prices currently reflect the expectation that the Fed will raise its rates by an additional 2 percentage points by year-end, while the ECB is expected to make its first hike in July and raise its rates by more than 1 percentage point by year-end. However, expectations are widely dispersed. And, given the long-standing uncertainty surrounding interest rate structures, turning the screw even sharper now would be less noticeable, at least on a psychological level, than at the beginning of the rate cycle. However, we expect more substantial surprises when it comes to a potential recession.
The reason for this is that China’s zero-Covid policy is undermining global economic prospects. The policy has gone on for longer than many market participants were anticipating as recently as the first quarter. Moreover, rising commodity prices are not supportive for economic growth. Over the past decades, central banks have been able to use monetary easing to head off looming recessions. But this time will be different, as they have inflation to contend with. This is raising risk premiums and causing investors to rethink their asset allocation strategies. As such, we could see a shift from risky asset classes to those perceived as safer options, as, in a recession, it’s ‘safety first’ and, accordingly, ‘quality first‘. IG corporates would benefit from such a trend, given that it is a high-quality segment with attractive spread compensation.
IG corporates should come into focus even in the event of a soft landing for the economy. Typically, IG-rated companies are financially solid and their bonds have historically outperformed weaker high yield bonds and equities during economic slumps. The additional return generated by the spread component also compensates better for inflation than government bonds or cash. At the moment, we prefer euro-denominated bonds within the IG market, as eurozone spreads have become far more attractive than elsewhere. Furthermore, their yields are as high as they were back in 2013. However, as yield curves have become very flat, we prefer short to medium-dated maturities and actively managed duration. In the meantime, the USD corporate bond market is likely to have to contend with sharply rising currency hedging costs, which are cutting painfully into net returns for investors from Europe and Asia.
We are currently favouring the financial sector, which is benefiting from the exit from negative interest rates. Even if the economy worsens considerably, banks now have strong capital buffers and are fundamentally solid. We also believe that bonds from non-cyclical sectors or short-duration hybrid bonds make sense in a defensively oriented portfolio. Generally speaking, the environment is, and will remain, challenging, but in the wake of steep price declines, we are cautiously positive on the outlook for IG corporates.