It’s not a new view but corporate bond markets continue to look attractive relative to the economic outlook. Right now, the bond market is offering its highest yields since the financial crisis and the level of credit spreads is comforting for investors that want exposure to the corporate sector but are shy of equity volatility. With central banks intent on keeping interest rates higher for longer, locking in the highest available yields for over a decade seems a sensible thing to do.
With inflation slowly coming down and central banks set to raise rates further - and keep them high for some time - credit markets appear to offer the best risk-adjusted returns to investors for now. Yields on investment-grade bond indices remain close to their highest since the global financial crisis. Unlike government bond markets, credit market yields don’t decline with maturity (in other words, credit curves are not inverted). This means that credit spreads are wider as we pass along the maturity curve. In turn, this offers a high probability, based on the historical evidence, that credit markets will provide positive excess returns (above risk-free Treasury returns, cash and returns from interest rate swaps). Investors are paid for taking exposure to the credit risk premium.
Upside for prices
In the current market, corporate bond prices are lower, the longer the maturity. Using the example of the European corporate bond market and the indices provided by ICE Bank of America, the average bond price for debt with maturities between seven and 10 years is currently 84 cents. Borrowers are typically contractually obliged to repay debt on maturity at par value (100 cents) so there is long-term upside price potential in much of the debt market. It’s a nice combination of yield and price.
Data watching points to continue hawkishness
The economic data from the US in January has pushed yields higher again. Expectations of central banks easing this year have been reduced and the peak in rates priced by the market has increased. For now, it seems prudent to take the view that inflation is coming down, albeit at a slower pace than some would have hoped for. Usual seasonal volatility in the inflation data will make it difficult to get a sense of the true underlying trend in the inflation data for a few more months. Having said that, the current rates of inflation, labour market tightness and the corresponding risk of higher wages are all too much for central bankers. They will stay hawkish and keep rates high and markets are coming to terms with that now. We may get lower rates in 2024 but for now investors need to assume that short-term interest rates are not going lower. If there is a central bank put, it is firmly locked away. What we don’t know is how bad this is going to be for economic growth. The current data is confusing. In the US retail sales rose 3% on the month – a lot stronger than had been expected. At the same time, the Philadelphia Fed’s Business Outlook index fell to its lowest level since 2009.
With the data all over the place, central bankers remain hawkish. Higher for longer short-term interest rates will continue to make exposure to the short end of the bond market attractive. Short-duration credit strategies are providing the highest risk-free yields for years. In the sterling market, the credit spread component of corporate bond yields sits the 70-75th percentile of the range that has been in place since 2000 – and higher if we exclude the global financial crisis and the spike in spreads during the onset of COVID-19. Historically, these spread levels have been associated with positive excess returns over three-year holding periods being achieved most of the time. Ignoring the relative valuation of credit to government bonds, all-in yields are very tempting. The sterling one-to-three year corporate bond index currently offers a yield to worst of 5.22%.
Yields have risen over the last year and as yields rise, duration typically falls. Again, using the BofA indices, the effective duration of the sterling corporate bond index fell from over 8.5 years at the end of 2021 to a low of 6.2 years at the end of 2022. This is a theme across markets, underpinning the attractiveness of bonds in general compared to the valuation regime that prevailed before the end of 2021. That means the threat of additional rate hikes to bond performance has diminished.
US spreads at some risk
The sterling and European credit markets are cheaper than in the US, at least in terms of comparable credit spreads. For some investors this is important but for others it is the overall level of yield, which remains higher in the US market than in either sterling or euros. If US credit spreads rose to be in line with the euro credit market, all else being equal, it would add between 30 to 40 basis points to yields and lead to lower bond prices. For that to happen would require some incremental bad news on the US corporate sector. It would also likely coincide with a worse equity market performance given that returns from credit premiums are positively correlated with returns from equities.
Earnings expectations still falling
This is still possible even though economic data continues to surprise on the upside. Earnings growth is slipping and has turned negative in the most recent earnings season. Analysts continue to revise down their numbers for 2023, which now stand 10% lower than the most optimistic forecasts made around the middle of last year. For the NASDAQ this is worse, with current forecasts 24% lower than the most optimistic. European numbers are coming down as well but the cuts to expectations have been less severe. It is fair to say that there is more risk in the US given the ongoing monetary battle against inflation. A sign of this is that the gap between US and European high yield spreads has traded to zero recently (US spreads had been lower for some time). This reflects an easing of European credit concerns but also some re-pricing of US credit risks.
And watch liquidity
Another risk to the US market is quantitative tightening. The Federal Reserve (Fed) still owns a lot of Treasuries but is now gradually reducing those holdings by $60bn per month. On an annual basis that is quite a chunk that the Fed will not be rolling over. As debt matures the Treasury will need to seek additional funds from the private sector to refinance the debt – and this year there is some $2.3trn maturing of which the Fed owns about $762bn. The demand for new financing from the Treasury – with a budget deficit of 4% to 5% of GDP – could impact on yields at some point. It could also impact on credit spreads through a kind of crowding out. There doesn’t seem to be any major liquidity concerns yet, as the Fed reduces the size of its balance sheet, but we need to continue to watch indicators like repo rates and commercial bank lending standards for any signs that the credit markets are becoming more difficult.
Looking good to hold
However, for now demand for credit remains robust, and companies are in a strong enough position to deal with higher financing costs. Profits growth has slowed but the corporate sector is still seeing strong nominal growth in sales and profit margins remain relatively healthy. The risk to returns is less than it is for equities and any widening of credit spreads in response to weaker economic data over the remainder of the year would likely be offset by some reduction in the risk-free rate. So far, this cycle is not a credit-distress cycle, but one characterised by squeezed household income and profit margins. Looking through the cycle, today’s spreads in credit markets provide investors with a medium-term investment horizon a potentially very good chance of healthy excess returns relative to risk-free fixed income, with much less volatility than an exposure to equity markets - even if, ultimately, stocks do provide more upside potential over similar time-horizons.
It was like the old days on Thursday with Manchester United going toe-to-toe with Barcelona. The 2-2 draw was flattering to the Catalans and makes for a potentially cracking re-match at Old Trafford next week. It’s amazing how much of a difference manager Erik ten Hag has made. The next few weeks will see the Reds compete at the business end of four separate competitions – with a Wembley final already assured. Your author is very excited - bring on the spring!
(Performance data source: Refinitiv Datastream).