What are the opportunities and outlook for US Investment Grade credit?
- All-in yield levels, combined with the prospect of attractive pull-to-par from discounted bond prices, offer investors an attractive entry point for US investment grade credit
- Given concerns over the US economy, we are more cautious on cyclical sectors and have been finding opportunities in more defensive sectors
- Short duration continues to look attractive, however there could be the possibility of extending duration depending on the future trajectory of US Federal Reserve policy
The current market environment
US investment grade (US IG) credit fundamentals remain strong, with corporate and financial bond issuers largely able to manage the increase in borrowing costs driven by tightening monetary policy. Generally, balance sheets also remain healthy, as confirmed in the recent round of quarterly earnings reports. So while we expect the US to enter some sort of mild economic contraction, we do not expect that to be accompanied with the kind of credit environment experienced in previous recessions.
US IG investors are still able to access yield levels not experienced since 2009, mainly thanks to the increase in government bond yields which has come through with over 500bps of interest rate hikes by the US Federal Reserve (Fed) since the start of 2022. There is still a yield pick-up available in US corporate credit of about 125bps of spread over government bonds, although this has been narrowing in recent months as the US economy has remained more resilient than previously expected. From a total return perspective, this has meant that the ICE BofA US Corporate Index has performed strongly, with a +2.97% return to August 31st, 2023, representing a 233bps outperformance to the equivalent US Treasury Index (+0.64%).
If the US does enter a mild recession, some amount of spread widening could be expected, but starting yields of close to 6% offer investors enough of a cushion to suggest that the prospects of losing money by investing in credit have now drastically decreased, compared to recent history like 2021 when yields were briefly lower than 2%. Alongside this, technical factors remain strong enough to suggest that any widening of spreads should be met with buyers.
The average dollar price of the US IG market remains discounted at 88, not as a reflection of corporate fundamentals or the ability of issuers to refinance, but in relation to what has been happening with interest rates. So, this means that on top of starting yields, investors may also benefit from capital appreciation as these bonds pull-to-par as they reach maturity. This pull-to-par will occur quicker for short-duration strategies given the lower average maturity.
Although the relative attractiveness of short-term money market instruments and cash has increased as a result of the increase to the risk-free rate, over a medium-term period, cash rates are likely to decline from current elevated levels, even if markets are not yet pricing in the realistic prospect of rate cuts.
Therefore, we believe that by investing in corporate credit, investors should benefit from locking in that yield for a fixed time horizon, rather than having to roll over short-term money market investments every 3 months or so – each time at potentially a lower level than the former.
Opportunities across sectors
Despite concerns over the US economy, the new issue market has remained healthy, with demand still strong despite reduced volumes. We have been favouring more defensive sectors, where we have been finding attractively valued opportunities in areas such as Utilities, Telecom, Healthcare and Consumer Goods. Having taken off risk, we are adding to more opportunistic bets when we see companies coming to market with concessions.
Within the Banking sector, recent earnings reports confirmed a more stable environment, with deposit bases holding up after the collapse of several regional banks earlier this year. This could lead to a pick-up in issuance, which we might view as an opportunity to cautiously add back to some of the larger money-centre banks having scaled back earlier this year.
The outlook for the US IG market remains impacted by the macro environment and a possible recession in 2023, which could weigh on sentiment for corporate spreads. That said, for the meantime, the upside of the economy doing better than expected is that credit markets are attractive, offering a higher return than government bonds.
Short-duration strategies are delivering positive returns and may well continue to do so. Further out the curve, despite a lower starting yield and continued volatility in rates markets, we believe extending duration will make sense at some stage as, on balance, we think the Fed will remain on hold for the rest of this year and will likely start easing policy midway through next year – even if the market is not yet pricing such an eventuality. In this scenario, intermediate and full duration strategies will start to look more attractive, with the potential for greater price appreciation in addition to coupon income.
For now, we remain cautious, as we wait to get more clarity on the macro situation. Even through this uncertainty, with yields close to 6% for high quality credit, we believe that US IG investors are getting paid to wait for the macro picture to become clearer.
References to companies and sector are for illustrative purposes only and should not be viewed as investment recommendations.
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