As the march to the end of the economic cycle continues and growth and inflation slow further, the debate over how the cycle turn will play out – i.e. hard landing or soft landing – is likely to grow louder. With the Fed signaling “higher for longer,” interest rates and borrowing costs increasing significantly over the past 12-18 months, as well as rising and more acute geopolitical risks, one would have expected the environment for corporate credit to be challenged. However, bond valuations appear unfazed as investment grade (IG) corporate spreads remain well inside of the level we deem to be long run fair value, or roughly 145 basis points (bps).
As the Fed started tightening monetary policy in 2022, market volatility rose and credit spreads widened, creating more attractive compensation for risk. While the value factor in IG2 exhibited weakness in 2022, year-to-date, it has performed well, with the top-quintile portfolio contributing significantly more to returns than the bottom-quintile portfolio (Figure 3). This trend has started to dissipate more recently; in September, value and momentum flipped, with value almost flat and momentum seeing its strongest performance since early 2023.
As IG corporate spreads have tightened back to 128 bps,3 a lot of those value opportunities have been harvested, and we may be seeing the initial signs that momentum in credit spreads may be turning as well. Overall, these are useful indicators to look at suggesting some caution ahead – corporate credit may start to feel the effects of tight monetary policy more clearly in the coming months.
1 See Overview: Systematic Active Fixed Income Signals (ssga.com) for further description of IG factors.
2 See Overview: Systematic Active Fixed Income Signals (ssga.com) for further description of IG factors.
3 Based on the Barclays IG Corporate Index, OAS, as of October 31, 2023.
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