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The current macroeconomic environment is nothing like what investors have seen in the past decade. High unexpected inflation coupled with aggressive monetary policy tightening has created a challenging environment for investors. The COVID pandemic followed by the Russia-Ukraine war has given rise to high inflationary pressures from both increased consumer demand and supply chain disruptions. As a result, governments worldwide had to unwind decades of loose monetary policy and increase interest rates at decade-high rates - The U.S. has raised rates by more than 500bps in the past 16 months. Amid higher rates and recessionary risks from overtightening of interest rates, one asset class presents itself as an attractive and reliable source of income - Investment Grade (IG) bonds. These bonds, issued by corporations with strong creditworthiness offer attractive total returns.
Attractive yields with low credit risk
IG bonds are bonds issued by corporations with strong credit ratings (BBB or above). During the past decade of low interest rates and high global economic growth, there was little case to be made for investing in low yielding IG bonds compared to equity or High Yield bonds. However, these days, U.S. IG bonds can yield up to 6%, compared to a range of 2-4% in the past decade. The Option Adjusted Spread (OAS) is a used as proxy for market pricing of credit risk, adjusted for embedded options. A higher OAS means that the market is discounting the cash flows of the bonds at a higher rate, indicating higher perceived riskiness of future cash flows. Compared to the average annual OAS figures, IG spreads do appear to be tight, which could indicate that IG credit is overpriced now. Hence, the next question IG credit investors should ask themselves is: Do current yields sufficiently cover the extra risk from investing in corporate bonds rather than risk free government bonds?
Source: Ice Data Indices, LLC, retrieved from FRED, Federal Reserve Bank of St. Louis. Note: IG Yield = ICE BofA BBB US Corporate Index Effective Yield; HY Yield = ICE BofA US High Yield Index Effective Yield; IG OAS = ICE BofA BBB US Corporate Index Option-Adjusted Spread; HY OAS = ICE BofA US High Yield Index Option-Adjusted Spread. Data as of 27 Aug 2023.
Healthy credit fundamentals limits spread widening
A recession has been predicted to happen for the past 18 months and yet each inflation print and labour market report points to a strong economy. Thus, corporations have been cautious with their balance sheet management. The graphs below taken from Schroders August Corporate Credit report shows cash balances available to service short term debt are at fairly elevated levels while leverage ratios are only slightly elevated from historical levels.
Source: Schroders Credit Lens August 2023. Data as of 1Q 2023, excludes Financials.
Technical dynamics supports IG bond performance
Fitch Ratings projects a slow down in issuance of IG debt in the second half of the year as the increase in interest rates has resulted in a higher cost of borrowing. The par-weighted average coupon for newly issued ‘BBB’ category bonds in 2Q23 was 5.5%, translating to an increase of 0.9% compared to those issued in 2Q22. Moreover, there is no pressing need for companies to refinance their existing debt for the rest of 2023. Out of the $5.3 trillion IG debt market, only $110 billion of IG debt is due by the end of 2023.
Source: Fitch Ratings. Data as of 30 June 2023.
Other than tight supply, there has also been a growing demand for IG bonds since the start of the year. Investors have been rotating into less risky corporate bonds which are now offering higher yields compared to historical levels amid an uncertain macroeconomic environment (FT). Taken together, a low supply and high demand for IG bonds creates a supportive technical backdrop for IG bond performance for the rest of the year.
Lock in yields now before interest rate cuts
As each CPI and PMI print comes in lower, along with signs of a loosening labour market, it is likely that the Fed will be cutting its interest rates early next year. The market is currently pricing in a 150bps cut to the Fed Fund rate in 1Q24. When rate cuts start, yields offered by new IG bond issues will not be as attractive as the levels offered now. Moreover, lower inflation translates to higher real rates - that means a 5% coupon earned by locking in to a 5Y IG bond now will be worth more in real terms.
With strong credit metrics and supportive technicals, I believe that IG spreads are fairly valued. Therefore, investors ought to lock in a steady flow of fixed income at historically high rates, offered by creditworthy companies, to ride out incoming recessionary risks.
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