Case for Investment Grade Bonds: US
It is only fair that recent US investment grade (IG) performance gives some investors pause; last year IG posted its worst total return on record.1 However, US Treasury market moves explained roughly 92% of last year’s -15.76% total return. Note that IG excess return only fell 125bps for the year.2 This indicates that the decline was more likely to be caused by hawkish Fed, rising Treasury yield, and tightening financial conditions than by corporate fundamentals.
Given that corporate balance sheets are healthy and increased income return will help to cushion against any future market price declines, we think IG could play an important role in portfolios at this stage of the cycle. IG corporate all-in yields have soared to a robust 5.5% on the back of an aggressive Fed rate-hiking cycle, while credit spreads have repriced wider given the recent turbulence in the banking sector.3
Nevertheless, elevated IG yields can be an opportunity for investors, especially since the higher income does not necessarily presage a rise in downgrades or a revival of the drawdowns seen in 2022.
Fundamentals
As we enter 2023, IG corporate fundamentals continue to benefit from a conservative credit posture from management teams and an economy that has proven to be more resilient than expected. The result? IG corporates are well prepared for a slowdown. Corporate balance sheets have significant cushions in the form of healthy leverage ratios that have fallen back to pre-COVID levels, and interest coverage that has risen to more than 13 times—a multi-decade high (Figure 1). Companies are still carrying debt at low interest rates that they locked in years ago, while liquidity remains strong with cash balances that are still above pre-COVID levels. These strong underlying credit fundamentals can make IG credit resilient in the face of tight financial conditions and a cooling economy.
Technicals
Supply fell to $1.4 trillion in 2022, down from $1.7 trillion in 2021 and $2.1 trillion in 2020.4 However, the asset class kicked off the year with strong issuance, led by banks. January issuance of $143 billion outpaced the 4-year average of $126 billion.5
Meanwhile, investor demand has improved significantly after record net outflows for fixed income IG in 2022. Investors could feel less pressure to go down in quality to stretch for yield, as IG all-in yields now are comparable to S&P 500 dividend yields and S&P 500 forward earnings yields. Already, pension funds and other yield-sensitive investors have been drawn to IG because of the juicier yields and low dollar prices.6 As many of these same investors sold bonds last year, a reupping in 2023 could further support the market.
Valuation
Today’s higher levels of income can act as a ballast against potential further increases in yields. To illustrate this point, Figure 2 shows a simple stylized scenario analysis of the impact of various rates and credit spread moves on the Bloomberg US Corporate Bond Index. In all three scenarios (base, bear, and bull), expected total returns are positive; on a probability-weighted basis, the expected total return on the index is almost 8%. Notably, yield carry is a significant contributor to prospective returns over the next 12 months. In a bear case, with spread widening driven by a “hard landing” in the economy, expected positive offsetting forces such as the Fed easing and Treasury rates falling would help to mitigate losses.
Figure 2: Higher Yields Can Help Insulate Returns Against Adverse Moves in Rates or Spreads
Scenarios: 12-Month Horizon
We have seen this rates versus credit diversification characteristic of the IG corporate index play out during the banking turmoil of the past week. After the run on Silicon Valley Bank, the spread on the index widened significantly from 120 bps on March 6 to over 160 bps on March 15. At the same time the 10-year Treasury yield fell from almost 4% to under 3.5% in a flight to quality. In this instance, rates won the tug-of-war and the index returned over 1% during this period—despite the high market volatility.
The Role of IG Bonds
For investors who have long relied on IG fixed income as a core and stable part of their portfolios, we believe that the traditional negative-correlation relationship between bonds and equities could return in 2023. With peak inflation behind us and a reprieve to aggressive tightening in sight (see: On the Brink of Overtightening), it is worth considering the asset class as a defensive play in portfolios. Corporates enter 2023 in good fundamental shape, alongside ample yields that can help cushion against volatile market pricing.
Furthermore, innovation has changed how bonds trade, and credit has been a beneficiary of these structural changes – which would argue for the increasing use of indexing and systematic approaches to investing in IG corporate bonds.Credit market innovations such as electronic trading and portfolio trading have led to greater transparency in corporate bond trading and lower transaction costs over time, facilitating the successful implementation of systematic strategies today. Figure 3 shows the steady improvement in market efficiency over the past decade. The Volatility-Adjusted BASI, or the ratio of MarketAxess’ Bid-Ask Spread Index7 to the VIX, has been trending downward, in line with the increase in electronic trading over time. Meanwhile, 40% of overall investment grade bond volume trades electronically.
This increased efficiency matters because systematic strategies can offer a differentiated return profile that can be complementary to many fundamental active managers, whose performance tends to be highly correlated with corporate bond index excess returns.