Riding the technical tailwinds

Read this article to understand:

• The technical tailwinds that are driving compression in investment-grade credit spreads
• How companies are faring in the higher rate environment
• Which sectors and regions are proving resilient and which are at risk

Corporate bond markets, and investment-grade (IG) credit in particular, enjoyed a strong start to 2024 as investors locked in the attractive high yields on offer ahead of expected rate cuts.

However, while inflation has gradually been coming under control in developed economies, it remains higher than central bank targets in many places – particularly demand-sensitive services inflation. Hence, rate-cut expectations have been revised, with markets paring back expectations for both the magnitude and number of cuts by the end of the year.

Against this backdrop, bond returns have proved volatile, but relatively attractive all-in yields have ensured demand for IG credit remains robust. While credit spreads are at historically tight levels, many investors remain attracted by the opportunity to lock in long-term income and the potential for total returns that IG corporate bonds offer, especially in an environment of heightened geopolitical uncertainty.

In this Q&A, senior portfolio manager Chris Higham offers his views on the state of the IG credit market and his expectations for the second half of the year.

What were the major developments in the IG corporate bond market in the first half of 2024?

Early in the year, inflation surprised on the upside in the US, casting doubts on the expectations for rate cuts that had propelled bond markets coming into 2024. As investors began pricing out the expected Federal Reserve cuts, we saw some spillover into the rest of the world. This contributed to disappointing returns in government bonds, which were negative in the year to end-June. 

Corporate credit spreads (the extra yield above equivalent government bonds) remained much more insulated from the volatility in the government bond markets. Corporate issuance has been very strong since the beginning of the year, mainly in IG but also, latterly, in high yield.

One of the surprises, and a big theme that has shaped IG markets this year, has been a very strong technical backdrop. The yields on offer, coupled with strong corporate earnings in Q1, proved to be very enticing for a whole host of investors, from pension funds to retail, and there has been strong demand for IG bonds in particular. This has been a key driver behind spread tightening and we believe spreads are currently at the tight end of fair value.

Given mixed economic signals and the volatility seen in bond markets this year, are you downbeat or optimistic for the second half?

Currently, our views are overall in line with the consensus in terms of the outlook for growth and inflation; namely, that growth is likely to remain resilient in the US with some spillover into Europe, and inflation will prove a challenge everywhere for the “last mile” of the battle against rising prices. Where we differ from consensus is around inflation in the UK, where we believe there is potential to see more interest-rate cuts than has been priced in.

Within credit markets, there are still areas of concern, with sectors that are vulnerable to a “higher-for-longer” environment, such as real estate and utilities, although there are signs of price adjustments to higher rates in the former.

Another area of significant concern is the leveraged-loan market, where borrowers are exposed to floating rates. This has contributed to a pick-up in defaults in the high-yield market. While rates may come down a little, we believe that they will not be significantly lower in the near future, hence companies will have to adapt to higher borrowing costs by improving their balance sheets and by having less debt on their books.

Overall, our outlook is quite balanced. We still prefer areas of the market that benefit from higher rates, such as financials and banks, and are not unduly concerned with idiosyncratic risks. Going forward, banks are likely to benefit from tailwinds in earnings. Bank stocks have performed very strongly over the last year, reflecting the higher-rate environment. While there are concerns over delinquencies or arrears as we move through a tight policy cycle, they have not materialised so far.

One of the big surprises this year, from an economic point of view, is just how well the labour market has held up despite higher rates. The services sector remains very strong, which again is good news for banks. While higher rates have been the main driver behind a pick-up in arrears in areas such as auto loans, credit cards and mortgages, these issues have occurred mostly in small pockets in the US. We are not overly concerned, and ultimately see these dynamics as a result of the normalisation of the market after the ultra-low levels we saw during the post-COVID period, but we are monitoring the risk arrears may increase further.

What about the health of corporates in general, and the prospects for issuance volumes?

Corporate results in the Q1 earnings season continued to be strong, and we expect the same in the Q2 quarterly numbers. What we saw in Q1 was a clear difference between the US and Europe in terms of credit spreads, where Europe easily outperformed across both IG and high yield (a more significant spread tightening over the period).

The recovery of GDP growth in Europe is one reason why spreads were bolstered in Q1, but there is also the matter of valuations, which are much more attractive this side of the Atlantic. Strong technicals in European markets have also been instrumental, particularly in high yield, where the number of outstanding bonds has been falling for the last 18 months or so.

However, there is a gap in IG credit spreads between Europe and the US, where European bond spreads have been wider than their US counterparts since February 2022 (see Figure 1). This contrasts with the trend over the last two decades, which saw the spread differential closer to zero (with the exception of the euro debt crisis period in 2010-2012).

The European market was generally of a higher quality and less dependent on oil in the past. But with the continuing Ukraine war and emerging fragmentation/political risks in member countries (France’s snap elections in June, for example), it is attracting a slightly higher risk premium compared to the US. 

An interesting development since interest rates began to rise is how little impact this has had on many IG issuers. The companies have, overall, become beneficiaries of the higher rates environment. Many are cash rich, but also have outstanding debt issued at a time when rates were low. Higher interest rates mean they are earning more on their cash than they have to pay out in interest payments on their debt.

While supply has been strong, there is a question mark on whether we continue to see lots more issuance for the rest of this year. It is possible that the issuance we have seen to date has been ”front-loading” by companies, trying to get their issuance out of the way while they can. If so, the technical backdrop is likely to get even stronger in the second half, given that central banks are also likely to deliver rate cuts. We believe there is still ample cash sitting in money-market funds, which could be diverted into IG assets as the cuts come through, allowing investors to move out on the credit curve. But we remain cautious given the tight spreads in IG.

You mentioned a cautious approach - how can IG investors best respond to the current challenging market conditions?

The tight spreads in the IG universe have increasingly pushed investors to allocate to riskier areas of the market. We disagree with this approach.

Given the current macro uncertainty and volatility, we believe one way to succeed is to ensure that you have the right investment process in place. Hence, at a time that other managers are reaching for yield in the riskier parts of the market, we believe it is better to focus on portfolio construction as a way to manage risks and identify alpha opportunities.

For instance, standard sector breakdowns, which allocate securities by industry group, may miss the significance of differences between credits, whether they lie in credit ratings, volatility, maturities or correlations. This is why we prefer to use custom sectors, defined by beta and historic volatility, as part of our portfolio construction approach. This helps us to avoid continually adding more and more high-beta securities to outperform the benchmark, and enables us to focus on targeting the same level of volatility as the benchmark, while staying broadly within the boundaries of IG and aiming to optimise returns.

Which sectors currently look attractive?

We like the wireless sector. This is because most big companies in the sector are very focused on debt reduction and strengthening their balance sheets. Take AT&T or Verizon for example; both are big names with very large market shares. Both have either made acquisitions or divested assets in recent years, having realised that they had piled on too much debt for markets’ liking. Hence, they have been using cashflows to pay down debt.

In the last decade or so, most companies have continued to lever up and diminish the strength of their balance sheets in the process. BT Group is a good example, which had a AA credit rating as far back as 2000, but is now rated BBB. Big incumbent companies or former monopolies with the ability to generate cash should focus on reducing debt if they are approaching the IG/high-yield ratings crossover threshold. We see a number of companies in the wireless sector that are very focused on doing just that.

The “Magnificent Seven” US tech firms dominate the stock markets; how are their bond issues performing in comparison?

These names would be very strong credits due to their huge cash piles, low capex and high margins, as well as being asset-light. However, there are not that many bond issues by the Magnificent Seven, and those that are around are trading at very tight spreads and very expensive levels. The companies typically have strong cashflows and do not need to borrow. While some have issued bonds in the past few years, it was probably to lock-in very low interest rates or for balance sheet optimisation – AAA-rated Microsoft is an example.

For now, given where interest rates are, we expect to see large corporate bond issuance only through mergers and acquisitions (M&A) activity in the tech sector. However, as these companies mature, they would naturally migrate down the credit spectrum. Even though the Magnificent Seven are growing very fast and markets are pricing exponential growth well into the future, at some point this growth will slow and they would need to optimise their average cost of capital and perhaps issue debt in the process. That could create more opportunities for credit investors to add bonds from these companies to their portfolios.