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Low spreads, high inflation and rising defaults: Navigating fixed income in 2023

With yields at decade highs, it might seem churlish to question the spread levels for corporate bonds over government bonds. However, high yields spreads have dropped from 5.9% in July last year to 3.9% today, and investment grade spreads from 1.7% to 1.2%. There is a question over whether they adequately reflect the outlook for the global economy. Do investors need to be cautious?

By the standards of the past decade, spreads appear normal. High yield spreads were notably higher from September 2014 to November 2016 (as measured by the ICE BofA US High Yield Index Option-Adjusted Spread), then lower from 2017 to 2019, before spiking in the pandemic, and then dropping to new lows from 2021. They had been trending higher until July last year, but have subsequently fallen as economic news has improved. It is a similar picture for investment grade.

However, many economists would argue that this is not a ‘normal’ environment. The global economic outlook has improved, but an inverted yield curve continues to point to recession in late 2023/early 2024. The World Economic Forum says some leading indicators still point to an imminent recession: “The Leading Economic Index, a measure that anticipates future economic activity, declined by 0.7% in June to 106.1 following a drop of 0.6% in May. This marks the longest streak of decreases since the lead-up to the 2007-09 recession.”

Whether a recession materialises, some economic deterioration appears likely and investors might expect higher compensation for rising defaults. There have been some signs of corporate distress emerging. Bloomberg recently referenced a $500bn “corporate debt storm” building over the global economy, saying the wave of corporate bankruptcies was building.

However, corporate bond fund managers argue that the picture is more nuanced. Absolute yields are high, thanks to rising government bond yields and corporate credit now offers competitive returns  with other asset classes. Peter Harvey, manager of the Schroder Strategic Credit fund, says: “When we look at BB-rated bonds, the overall yield is at a 10-year high. For the first time in a long time, credit is competing with equity and ordinary share capital for investor attention.”

Equally, he says, defaults are low for much of the corporate bond market: “Defaults on investment grade are incredibly low. At the top end of high yield, they are also low. The defaults for BB-rated bonds have ticked slightly higher, but are still less than 0.5% per annum, so with a 7-8% yield, the risk reward ratio looks good.” Defaults, where they have occurred, have generally been confined to the lower end of high yield or distressed credit.  

He adds: “Spreads are not at the cheapest point, but they are still above the median for investment grade and the top end of high yield. They are still relatively attractive.”

Spreads were notably higher during the Lehmans crisis or the peak of the pandemic when they hit 4% for investment grade and over 10% for high yield. However, few would argue that the environment is that bad today. Recession remains possible, but is more likely to be short-lived and shallow.

This should be supportive for corporate earnings. Harvey says: “Earnings per share expectations for Western economies are generally positive if commodities are stripped out, and materials such as steel. We continue to see strong earnings in IT and financials, and small positives for consumer discretionary, staples and healthcare.”

Stuart Chilvers, fixed income fund manager, Rathbones says that while it is not clear that investment grade credit spreads as a whole are particularly cheap if a recession is expected, there are still sectors of the market that are offering compelling value.

“For instance, we think financials look cheap having lagged the rally year-to-date following the stresses areas of the banking sector saw in March. In particular, we think Tier 2 bank bonds with relatively short-dated calls are providing attractive spreads and offer strong risk/reward characteristics.

“Earnings have remained resilient, capital ratios are strong (as the latest BoE stress test demonstrated) and call track-records from the large banks in these bonds have been excellent. A similar argument can be made for subordinated insurance bonds, where solvency ratios have generally benefitted from the rising yield environment.”

Harvey also sees value in financials, particularly in the wake of the Credit Suisse problems and has been picking up bonds at cheaper prices. He has also been tactically buying in the real estate sector, but his highest weighting is in healthcare. The Schroder Strategic Credit portfolio has an average credit rating of BB – the top end of high yield. However, he is avoiding the more distressed part of the market, believing this is where problems will emerge if the economic environment worsens.

The biggest risk is inflation, but this is a risk to the whole bond complex, rather than just the corporate bond sector, says Harvey. Equally, with better news on inflation from the US, US and Eurozone in recent months, and central banks apparently coming to the end of their rate raising journey, this appears to be a diminishing risk.

Spreads may not look particularly wide for a moment when growth is weakening, but nor do they appear excessively optimistic. While there are vulnerabilities in the lowest-rated companies, and default rates may tick up, there are relatively few signs of this hitting investment grade or the top end of high yield. Equally, for the first time in a decade, yields look competitive with dividends, which may continue to draw capital to corporate bonds.

Part of the Mark Allen Group.