The right temperature for corporate credit?

Please note: This article is more technical in nature than our typical articles, and may require some background knowledge and experience in investing to understand the themes that we explore below.

Key points

• After the recent decline in investment grade bond yields, the relative attractiveness of the debt has diminished. Despite the retreat, yields in this segment still appear to be on the high side. That said, with a sustained recession looking unlikely and inflation moderating gradually, the conditions for investment grade bonds appear to be about just right
• Corporate bond spreads (or the difference between their yield and that for the respective government debt) have tightened substantially and now seem priced for perfection. This leaves spreads exposed to some widening in the short term and they could even head back to their long-term average of 130 basis points in the US for example
• That said, absent of major economic or financial crises, historically interest rate movements, rather than those for spreads, typically exert the most influence on corporate bond yields. This means that over the medium-to-longer term investment grade bond yields might fall even further

It is not only in the UK that the weather is a much discussed topic. It goes without saying that it’s rarely the right temperature or the ideal breeze. What constitutes the best weather is subjective, but for many people, conditions are frequently too cold or too hot, rather than just right. What is the right “temperature” for corporate bonds, or the credit market more generally?

To stay with the weather analogy, it could be argued that corporate bonds prefer a mild climate and do not mind a few clouds, may enjoy a fair breeze or some light showers even; as long as things do not morph into a storm. In finding their ideal home, corporate bonds might be partial to coastal areas of the UK or Ireland during springtime. 

Still attractive to jump on the investment grade train?

Since last October, the average yield for investment grade bonds has declined from the peak — at 6.6% for US dollar-denominated debt, 6.7% for sterling and 4.7% for the euro — by more than 100 basis points (bp), as shown in the chart. The fall in yields occurred at a time when growth in the advanced economies seemed to cool along with inflation, while a severe and long-lasting recession seemed increasingly less likely to materialise: optimal conditions for corporate bonds. 

Investment grade bond yields remain elevated

Despite the recent decline, yields for US dollar-, euro- and sterling-denominated investment grade bonds are still elevated

Spread levels undemanding

The increased flow of funds into corporate bonds in recent months has resulted in very tight spread levels (the premium over respective sovereign bond yields). For instance, US spreads are trading at 90bp (see chart), close to the lower end of the range during the last 20 years. The average level over that period was 150bp (or 130bp over the last 35 years). Although spreads might be tight, this need not signal an imminent widening.

Investment grade credit seems to do particularly well against government bonds (excess return) if the annual growth in gross domestic product is between one to two percent, as seen in the US since 1948. A “soft-landing” scenario, as seen in mid 1990s, may lead to a period of gradually tighter trending spreads.

In addition, cash balances, which in the US are now above $6 trillion, are flowing back into higher-yielding assets. These “hunt-for-yield” flows could accelerate when the US Federal Reserve (Fed) decides to start its cutting cycle, making lower cash yields a reality. 

Spread levels undemanding

The spreads on US dollar, euro- and sterling-denominated investment grade bonds and high yield debt seem undemanding at current levels when compared with the 15-year mean

Is a trend change overdue?

At least in the short term, spreads may head back towards there 130bp average, or perhaps even 150bp if the Fed and other leading central banks delay cutting rates until the second half of the year, or even later. Rate volatility could also spillover to spreads. A pattern observed during the last two years. 

However, spread levels over 250bp would likely require much weaker economic growth, or even a recession, like seen in 2002 or 2011. This seems less likely, for now.

Is substantial spread repricing near?

Higher corporate bond yields (triggered by elevated rates and spreads) might be on the cards in the coming months. However, over the medium-to-longer term investment grade yields should be prone to declines, as rate moves have the highest impact on corporate bond yields, rather than spreads.  

Spread widening induced by growth uncertainties usually goes hand in hand with lower rates (higher probability of cuts), as highlighted in ‘When the race is on during cycles’. This pattern could be observed in the last 12 rate cycles, stretching back to 1974, bar those seen in 2008 and 2020. 

A large credit downgrade wave seems unlikely

Within the investment grade segment, default rates seem less relevant, unlike the potential for rating downgrades by credit-rating agencies, and most importantly the bond pool at risk of being downgraded to the speculative (or high-yield) sector, known as potential fallen angels.

The pool increased once again last quarter of last year. This marks the fifth increase during the last six quarters and sits above the average level seen between 2016 and 2019. Therefore, selection remains key in the credit market, but weak spots can be identified. According to rating-agency Moody’s, 63 non-financial issuers can be found in the potential fallen-angel zone, with over $400 billion of debt.

Almost half of the potential fallen angels are found in Asia, while the US pool of fallen angels fell during the fourth quarter of 2023. A soft-landing scenario in America, as seems likely, should prevent a large wave of downgrades; not least as leverage ratios have slightly improved during recent quarters.

After the rally, and at current tighter spreads, the relative attractiveness of investment grade bonds has somewhat diminished. From an absolute-return perspective, yields in this segment still seem to be high. The risk of some limited repricing in the shorter term remains, but overall weather conditions for investment grade bonds appear just right.

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