James Vokins and Chris Higham explain why investment-grade bonds still offer value despite persistent market uncertainty.
Read this article to understand:
- Where we are in the current economic cycle
- The factors driving tight credit spreads
- Why investment-grade corporate bonds continue to offer opportunities
Sometimes it pays to challenge conventional wisdom. As we wrote in our January outlook, in contrast to the consensus view, we expected inflation to remain sticky and more rate rises this year.1 A few months later, markets came to the same conclusion.
As detailed in our Q3 House View, global economic activity has proved stronger than expected, despite the supply-side shocks that contributed to the rise in inflation.2 Growth accelerated in the first half as a drop in energy prices lowered headline inflation even as the services sector took off, benefiting from pent-up demand. At the same time, tight labour markets boosted wages and incomes.
The economic cycle is currently in its late stage, when growth slows but remains positive, and high inflation and tight labour markets lead to higher interest rates. Late cycles end when activity contracts and economies enter recession. So far, economies have proven resilient, delaying the end of the cycle.
In the medium term, we believe the risks to growth are to the downside. Major central banks in developed economies have not yet won their battle to control underlying inflation. Higher unemployment and below-trend growth are necessary to deliver softer wage growth and reduce inflationary pressures. That suggests interest rates will stay higher for longer.
What next for IG?
Where does this leave investment-grade (IG) corporate bonds? The extra yield available on IG relative to government bonds – 5.3 per cent versus 3.2 percent – looks reasonable given healthy company profits and the fact defaults are relatively rare in the investment-grade asset class.3 Defaults on IG bonds stood at 0.1 per cent globally, or 0.3 percent in the US, in the 12 months to end-July 2023, according to figures from rating agency Moody’s.4
While tight financial conditions – triggered by sharply rising rates and growth fears – have led to vastly reduced new issuance and refinancings in high yield, IG activity looks comparatively healthy. US dollar-denominated non-financial corporate supply is currently near the highest levels of any non-COVID year on record (at approximately $450 billion, as of June 30, 2023).5
Even though conditions could change in 2024 and 2025, when refinancing maturing debt could prove problematic if it coincides with a recession, we continue to see IG as the most attractive area in fixed income given current valuations, starting yields and default dynamics.
The puzzle of corporate-bond valuations
These are unusual times in bond markets. While governments are borrowing more and having to pay more interest on their debt, major central banks are selling bonds as part of ongoing quantitative tightening.
The current macro environment brings uncertainty, chiefly on inflation
The current macro environment brings uncertainty, chiefly on inflation. This raises the question: will central banks be able to find the right level of interest rates to tackle rising prices without tipping economies into recession? It is hard to see at what level interest rates might peak and, in turn, where government-bond yields will settle.
The latter point is critical to valuations, as corporate bonds are priced based on equivalent government-bond yields, plus a spread to compensate investors for the credit risk (the credit spread).
Historically, there has been a negative correlation between credit spreads and government-bond yields. In theory, better economic growth boosts companies and tempts investors away from the relative safety of government bonds, leading to higher government-bond yields and tighter credit spreads – and vice versa. This relationship broke down in 2022, when government-bond yields and credit spreads moved in the same direction, but has since reverted to its traditional pattern (see Figure 1).
Figure 1: Inverse relationship: US Treasuries yields and investment-grade credit spreads (correlation)
Past performance is not a reliable guide to future performance.
Note: 100‑day rolling correlation of yields, generic 10-year US Treasuries versus Bloomberg Global Aggregate Corporate Index.
Source: Aviva Investors, Bloomberg. Data as of July 11, 2023.
Given the substantial rise in government-bond yields over the last 12 months, credit spreads now make up a smaller percentage of the overall yield of a corporate bond. To illustrate, in the 12 months to the end of Q2 2023, US Treasury yields widened by around 120 basis points (from 3.1 per cent to 4.3 per cent). Over the same period, IG corporate bond yields widened by 80 basis points (from 4.7 per cent to 5.5 per cent), meaning the credit spread narrowed from 160 basis points to 120 basis points. As a result, the credit spread now only makes up around 20 per cent of the overall yield of an IG corporate bond, compared to around 35 per cent 12 months ago.6
Spreads have tightened in both IG and HY corporate bond markets over the last few months
Expectations a recession will be averted have led investors to bid up the price of corporate bonds, especially in high yield, where current yields are deemed sufficient compensation for the risk. Thus, spreads have tightened in both IG and HY corporate bond markets over the last few months. However, this raises the question of whether they will fully compensate investors for the risks ahead.
Judged against the risk of overtightening by central banks, and the likelihood we are in the late stage of the economic cycle when the probability of recession is elevated, corporate bonds could be seen as expensive.
However, several factors imply valuations remain fair, including the current picture of healthy corporate profits, cash reserves and interest coverage. For example, the interest coverage ratio for non-financial US companies stood at 16.2 times at the end of June, higher than the long-term average of 14.9 times since 2006.7
Credit markets have also been supported by contrasting technical factors – IG by strong demand, as evidenced by continuing inflows into the market (see Figure 2), and HY by a lack of new supply. However, given the uncertain macro picture, investors need to be selective.
Figure 2: Healthy flows into Europe and US IG (US$ billions)
Note: Bloomberg Intelligence, fund flow data.
Source: Aviva Investors, Bloomberg. Data as of June 30, 2023.
Compelling opportunities in IG credit
IG corporate bonds are a good proxy for government bonds. While their yields rise as rates go higher, they can deliver a higher income and total return than government bonds due to their slightly riskier nature.
Yields on IG corporate bonds have risen in line with the substantial rises in government bond yields
Yields on IG corporate bonds have risen in line with the substantial rises in government bond yields. Average prices for these bonds are now at their lowest levels since the global financial crisis (GFC), and the higher starting yields should allow room for stresses in the market to be absorbed. For this reason, we believe IG valuations look compelling.
Yields in this part of the market are just over five per cent, 2.5 times the dividend yield on global equities.8 In the last decade or so of ultra‑low interest rates, such yields were the preserve of HY or emerging-market debt.
There is also the anomaly of the yield ratio of HY debt over IG to consider: it has collapsed in recent months to levels not seen since before the GFC. At just over 1.5 times as of July 11, 2023, it is below the historical range of around two-to-three times (see Figure 3).
Figure 3: Collapsing yield ratio: high yield over investment grade
Past performance is not a reliable guide to future performance
Note: Ratio showing yield to worst of Bloomberg Global High Yield Corporate and Global Aggregate Corporate indices.
Source: Aviva Investors, Bloomberg. Data as of July 11, 2023.
This in part reflects the fact yields on global HY debt have not moved much in recent months, remaining around 8.5-to-nine per cent since February 2023, despite the macroeconomic outlook.8 But in a recession or even an economic slowdown, a number of HY companies are likely to default, eroding these returns. Given Moody’s global default rate expectations for the sector next year of between 4.3 per cent (the rating agency’s base case) and 9.9 per cent (its “moderately pessimistic” forecast), yields of around nine per cent start to look less attractive.10
Remaining in the sweet spot
The IG market is well-diversified in terms of sectors and geographies. However, changes in interest rates have exposed vulnerabilities. There is now more dispersion across sectors and individual names – some are being unfairly treated because of their perceived association with a weaker credit in the same industry, such as structural concerns for the office subsector impacting others in real estate. However, the current environment might offer opportunities to invest in these bonds, not just because of higher yields, but also because of dispersions that can be exploited in an active strategy.
The higher duration in IG markets mean investors should be able to rely on current levels of return until the bonds mature
There is a view among some investors that short‑term cash rates – risk‑free and yielding the same or higher than investment-grade corporate bonds – offer better value. But this ignores the possibility of recession ahead and the fact those short‑term rates are – as the name implies – short term and carry reinvestment risks. In contrast, the higher duration in IG markets, where defaults are rare, mean investors should be able to rely on current levels of return until the bonds mature.
For these reasons, we believe IG corporate bonds are relatively more attractive on a risk-adjusted basis and able to deliver a higher total return than cash. Additionally, as the pace of interest-rate hikes slows, interest-rate volatility should subside, which would be supportive of these bonds’ credit spreads. In our view, the high level of income should provide investors with room to absorb volatility through the end of the cycle.
With sound corporate fundamentals, strong technical factors and compelling valuations, IG corporate bonds are worth a closer look.
