Fixed income is finally delivering income!
The 10-year US Treasury (UST) yield has spent most of the last decade between 2.50% and 0.50% and investment grade (IG) credit spreads have certainly traded in a tight range as well.1 As a consequence of this incredibly low yield environment, investors were pushed to look for additional yield in lower-quality asset classes. This rationale is based on the fact that fixed income investors need and want income. Moreover, higher-quality, longer-duration assets had significant total return risk purely due to the potential for an eventual rise in interest rates. This is exactly what we have seen year-to-date in 2022.
Exhibit 1 below can help set the tone for how the US IG market has behaved over the course of 2022 and consider the range of outcomes we might expect in 2023. It shows how volatility in UST rates and credit spreads can impact the total return over a one-year investment horizon.
Below is a sample range of outcomes for 10-year US investment grade, and what happened is in orange 2.50% UST yield rise and 0.75% spread widening. (Most underperformance driven by 2.50% rise in US Treasury yields.)
Exhibit 1: Hypothetical Forecasted Return Matrix
As of December 31, 2021
Source: Bloomberg; Bloomberg US Corporate Bond Investment Grade Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results. There is no assurance any forecast, projection or estimate will be realized.
At the start of 2022, the UST rate was 1.50% and IG credit spreads were 1%. The number in green, a total return of 2.50%, is the outcome if nothing had changed. In other words, if UST yields and credit spreads didn’t change, the hypothetical investor would earn 2.50% over the year. However, as we all know, over the course of 2022 UST yields rose by approximately 2.50% and spreads widened by approximately 0.75%. The orange highlights show that the result is a total return for 10-year IG of approximately -15%/-19%.
If we look forward toward potentially less volatile UST rates and consider the much higher starting point for both yields and spreads, one could make the argument that there is a much more asymmetrically positive range of outcomes for US IG credit looking forward. See Exhibit 2 below.
Today: Positive asymmetry to total return outcomes for investment grade given starting point for US Treasury yields of 4% and investment grade spreads of 1.75%, and potentially less rates volatility from here.
Exhibit 2: Hypothetical Forecasted Return Matrix, Part 2
As of November 2022
Source: Bloomberg; Bloomberg US Corporate Bond Investment Grade Index. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results. There is no assurance any forecast, projection or estimate will be realized.
Though there was certainly some weakness in widening credit spreads, rising UST yields drove most total return losses in fixed income year-to-date. We believe that this outcome has created a path for longer-term tailwinds for IG credit going forward. First and foremost, even if there is a recession, the probability of default for IG issuers is very low. What this means for higher-quality fixed income sectors, like IG, is that investors from this point forward will get the benefit of higher yields and duration as a potential defensive mitigator to any possible spread volatility if the US economy enters a recession. In a recession, UST yields will likely rally, which can provide a big positive boost to total returns. Moreover, it would help offset any potential weakness from widening credit spreads, as shown in the table above. The range of outcomes where IG credit investors could potentially lose money from today’s starting point has lowered considerably. This is not to say that spreads won’t widen; they can widen significantly if we enter a recession. But we have reached a point in time where investors can play both offense and defense through their allocations to US IG corporate bonds. We believe the defensive benefits of higher UST yields can materially offset credit spread weakness going forward. Fixed income is finally delivering income!
Credit spreads have widened since the beginning of the year and remain above five- and ten-year averages after hovering near historically tight levels for most of 2021. In terms of fundamentals, muted consumer demand, higher input costs and a strong US dollar have negatively impacted corporate profitability. However, balance sheets remain generally robust, providing most IG corporates with more financial flexibility to navigate a period of slowing economic growth, in our view.
Overall, we believe that yields in the asset class are better, and the risk-reward balance of current valuations has improved materially compared to the start of the year. This makes IG corporates a more attractive place for investors seeking relatively safe income. However, due to ongoing market uncertainty, slowing growth and deteriorating fundamentals, we acknowledge spreads can go wider and are certainly up in quality today within our US IG allocations to preserve liquidity and take advantage of any potential volatility in markets.
Interest rates likely to remain higher for longer
Given a very uncertain environment, it is likely that volatility will remain high over the foreseeable future. Increased levels of volatility are driven by limited visibility into the Federal Reserve’s (Fed’s) policy tightening path, for one, as investors keep hoping for an earlier pause in policy rate hikes and some are expecting rate cuts in late 2023. Our view is that rates will go higher than markets anticipate and stay higher for longer. Secondly, since Fed Chair Jerome Powell appears more concerned about not tightening enough rather than overtightening, we do believe a shallow recession is likely over the medium-term. However, this doesn’t appear to be priced into earnings estimates. In times of increased volatility, higher-quality credits with strong fundamentals and less sensitive end-demand are likely to outperform. We are therefore pushing more of our portfolio risk into non-cyclical sectors and still believe the US financial sector has strong risk-adjusted return potential given elevated spreads and very strong capital levels.
Coping with challenges ahead
Looking ahead, companies are going to face some challenges. Margins are likely to continue to feel the squeeze from elevated labor, financing and input costs. Corporates are already feeling the effects of significant wage increases as evidenced by the first layoff announcements from various technology companies. While companies are still benefiting from interest costs that have hovered near generational lows for more than a decade and have frontloaded borrowing, rising rates will certainly bite into the broader macro economy from both consumers to future corporate borrowing needs. Also, though we have seen improvements in supply chain issues, inflation will most likely stay higher, even if it stabilizes or retreats, and for longer than consumers or markets are accustomed to. This will continue to impact global growth.
Considering our expectations for a potentially challenging market environment over the near to medium term, we believe that cyclical consumer-focused industries and companies with high levels of exposure and sales to weaker markets, such as Europe, will likely underperform. We are also less excited about commodity sectors; although fundamentals are decent and commodity prices may hold up, valuations are stretched to us. Weaker economic growth can and certainly should cause spread volatility in these sectors as aggregate demand slows.
Endnote
1 Source: Bloomberg; Bloomberg US Corporate Bond Investment Grade Index. September 30,2011–September 30, 2022. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future results.
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