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Bond Valuations Remain Unfazed Monthly Credit Commentary – October 2023

Global Head of Active Fixed Income
Senior Portfolio Manager
Fixed Income Portfolio Strategist

Environment and Outlook for US Credit

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).

  • Credit quality at the index level continues to improve. Positive credit ratings momentum continues in both investment grade and high yield. The upgrade/downgrade ratio for IG is 3.6x YTD after a strong 3.9x in 2022. The BBB rated segment of the index is at 47%, which is down from a peak of 51% in 2019.1
  • Demand for long corporates remains strong. Lack of long end supply and higher all-in yields are driving demand for long paper – reinforced by corporate defined benefit pension plans continuing along their de-risking path as rates have moved higher.
  • Credit fundamentals have peaked, but they have not (yet) cracked. While top-line and bottom-line growth rates have slowed considerably, they remain positive (Figure 1). Despite this softening, corporate balance sheets remain well positioned to weather the coming economic slowdown.

Has the Value Factor Run Its Course in 2023?

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.

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