Strong tailwinds
Strong tailwinds
Adam Darling and Harry Richards say investors have a once in a generation opportunity to lock in high yields in the investment grade corporate bond market.
Investment grade bonds are now trading near the cheapest levels since the Global Financial Crisis, which provides a rare opportunity for investors to lock-in high yields in a relatively safe part of the credit market as potential recession looms.
Major central banks including the US Federal Reserve (Fed), the European Central Bank and the Bank of England (BOE) have boosted their policy rates aggressively over the past year to induce a slowdown in growth and tame inflation. That effort is already bearing fruit.
US consumer prices index rose 3% in June, above the Fed’s 2% target, but much below the 9.1% recorded in the same month of 2022. In the UK inflation recently surprised to the downside as well and is now poised to quickly decelerate in the coming months. Inflation in other regions is also slowing. We believe central banks have broken the back of inflation.
That’s good news for investment grade bond investors, who can now look forward to much higher real returns, with market yields having trebled over the past two years. As growth falters, defaults at the lower rung of the credit spectrum may increase, further bolstering the appeal of high-grade bonds.
Major central banks including the US Federal Reserve (Fed), the European Central Bank and the Bank of England (BOE) have boosted their policy rates aggressively over the past year to induce a slowdown in growth and tame inflation. That effort is already bearing fruit.
US consumer prices index rose 3% in June, above the Fed’s 2% target, but much below the 9.1% recorded in the same month of 2022. In the UK inflation recently surprised to the downside as well and is now poised to quickly decelerate in the coming months. Inflation in other regions is also slowing. We believe central banks have broken the back of inflation.
That’s good news for investment grade bond investors, who can now look forward to much higher real returns, with market yields having trebled over the past two years. As growth falters, defaults at the lower rung of the credit spectrum may increase, further bolstering the appeal of high-grade bonds.
Long duration
2022 and early 2023 saw one of the most extreme increases in government bond yields in modern history as the fear of sticky high inflation led central banks globally to embark on aggressive rate hiking cycles. Investment Grade bonds suffered in this environment because of their relatively long duration, and hence higher exposure to interest rate volatility.
The pain was even more pronounced in the Sterling high grade bond market, especially in recent months, as persistently high inflation in the UK caused the BOE to take an even more hawkish stance than other central banks.
The pain was even more pronounced in the Sterling high grade bond market, especially in recent months, as persistently high inflation in the UK caused the BOE to take an even more hawkish stance than other central banks.
Improving prospects
All that may be set to change for the better now as central banks are near the end of their monetary tightening spree, and leading indicators of the economy suggest that inflation globally will continue to fall towards the 2% target. In this environment we think that longer duration assets, such as investment grade corporate bonds, could fare better both in terms of absolute and relative returns in comparison to other asset classes.
In recent months risk assets and especially equities have rallied hard on the basis that perhaps a “soft landing” might be achieved after all.
We believe such an assumption might be misplaced as leading economic indicators in the Eurozone, the UK and China signal the potential for a widespread recession in developed markets. Additionally, history tells us that monetary policy tends to act with “long and variable lags”. The lagged effect of past interest rate hikes is only now starting to percolate through many economies. We have also witnessed a significant tightening in bank lending standards and demand for credit which historically have been precursors to economic slowdowns.
If we were to face a material recession across developed markets, inflation will likely fall even further, and interest rates could be cut aggressively.
This would be a positive scenario for high quality long duration assets as yields on government bonds would see a meaningful decline from current levels. Investment grade bonds, with low default risk and robust issuer characteristics, would be expected to materially outperform riskier asset classes into a weakening economic environment.
Even if the path towards lower interest rates is not linear, current yield to maturity for investment grade bonds provides a much better starting point for investors when compared to 12/18 months ago, providing a more asymmetric payoff profile in different scenarios for rates.
We believe such an assumption might be misplaced as leading economic indicators in the Eurozone, the UK and China signal the potential for a widespread recession in developed markets. Additionally, history tells us that monetary policy tends to act with “long and variable lags”. The lagged effect of past interest rate hikes is only now starting to percolate through many economies. We have also witnessed a significant tightening in bank lending standards and demand for credit which historically have been precursors to economic slowdowns.
If we were to face a material recession across developed markets, inflation will likely fall even further, and interest rates could be cut aggressively.
This would be a positive scenario for high quality long duration assets as yields on government bonds would see a meaningful decline from current levels. Investment grade bonds, with low default risk and robust issuer characteristics, would be expected to materially outperform riskier asset classes into a weakening economic environment.
Even if the path towards lower interest rates is not linear, current yield to maturity for investment grade bonds provides a much better starting point for investors when compared to 12/18 months ago, providing a more asymmetric payoff profile in different scenarios for rates.
UK credit
The UK investment grade market looks particularly interesting at the moment. Credit spreads are relatively cheap compared to long-run average/median spreads and look cheap relative to other investment grade markets globally (such as the US and Europe). This contrasts with tight spreads, for example, in the high yield market.
The UK government is heavily indebted, and the consumer is also experiencing stress from higher interest rates which we expect to act as a headwind to growth in the coming months. What’s not good for the economy is invariably good for bonds as falling growth and inflation support the return potential of long duration assets. However, careful credit selection will be key as companies and their bonds will perform differently in a weaker, more fearful market.
Recent volatility has created interesting tactical opportunities in sectors such real estate and financials. Real estate, in particular, is one of the sectors that suffered the most from the increase in interest rates. While fundamentals and certainly current news flow do not look bright for the sector as whole, in certain situations markets appears to have overreacted. Companies with high quality portfolios that are largely unencumbered, modest leverage and low prevalence of floating rate debt can offer attractive value. In contrast, we are quite cautious on sectors with a higher degree of cyclicality such as consumer discretionary or industrials.
Across ratings, we see limited value in the A-rated segment of the market, while BBBs seem to offer more compelling risk/return prospects after their recent underperformance. Retaining some very high quality AAA and AA rated bonds in a portfolio helps to hedge against future volatility.
The UK government is heavily indebted, and the consumer is also experiencing stress from higher interest rates which we expect to act as a headwind to growth in the coming months. What’s not good for the economy is invariably good for bonds as falling growth and inflation support the return potential of long duration assets. However, careful credit selection will be key as companies and their bonds will perform differently in a weaker, more fearful market.
Recent volatility has created interesting tactical opportunities in sectors such real estate and financials. Real estate, in particular, is one of the sectors that suffered the most from the increase in interest rates. While fundamentals and certainly current news flow do not look bright for the sector as whole, in certain situations markets appears to have overreacted. Companies with high quality portfolios that are largely unencumbered, modest leverage and low prevalence of floating rate debt can offer attractive value. In contrast, we are quite cautious on sectors with a higher degree of cyclicality such as consumer discretionary or industrials.
Across ratings, we see limited value in the A-rated segment of the market, while BBBs seem to offer more compelling risk/return prospects after their recent underperformance. Retaining some very high quality AAA and AA rated bonds in a portfolio helps to hedge against future volatility.
Credit selection
To be sure, as active managers we place a lot of emphasis on credit selection in the investment grade market and try to avoid underperforming sectors and bonds of debt-laden firms that could be potentially downgraded. The crisis faced by Thames Water, Britain’s biggest water supplier, is a stark reminder of the importance of fundamental research. Even if there are no defaults, one needs to watch for credit spread volatility.
Overall, as we gear up for a recessionary world, we believe investors will flock to the relative safety of the investment grade market, with the attractive yield on offer a bonus. The market now offers an attractive entry point for locking in high yields, with the added advantage of boosting real returns as inflation softens. The shock of the drawdown in the bond market through 2022 means investors are a little cautious about their exposure to the asset class but that’s typically a good indicator of a favourable entry point.
Overall, as we gear up for a recessionary world, we believe investors will flock to the relative safety of the investment grade market, with the attractive yield on offer a bonus. The market now offers an attractive entry point for locking in high yields, with the added advantage of boosting real returns as inflation softens. The shock of the drawdown in the bond market through 2022 means investors are a little cautious about their exposure to the asset class but that’s typically a good indicator of a favourable entry point.
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