US companies’ earnings are strong enough that money managers like T. Rowe Price Group Inc. and PGIM Inc. expect corporate bonds to outperform Treasuries over the next 12 months, even if the economy suffers.
More than half of the corporations in the S&P 500 index have posted results so far, and are performing better than analysts had feared. Even though earnings per share have fallen about 4.5% on average from last year, 80% of companies are topping earnings estimates compared with a long-term average of 65%, according to Bloomberg Intelligence.
Firms came into 2023 on strong footing, with sales per share for S&P 500 companies at an all-time high. Cash holdings were at levels that would have been a record pre-pandemic, even if they’d come off their peaks, according to data compiled by Bloomberg.
“The strength of current US earnings highlights the supportive fundamentals underlying corporate credits,” said Mike Della Vedova, a global high-yield portfolio manager at T. Rowe. “We would expect good decent positive returns and excess returns over government curves.”
Excess returns for US corporate bonds, a measure that looks at gains compared with Treasuries, are rebounding from their under-performance in 2022, when fixed income broadly sold off. Investors have been buying corporate debt recently, betting the Federal Reserve is nearing the end of its rating-hike cycle and that companies are in good shape to cope with near term risks like a recession.
With a downturn this year likely, the Fed will pivot to cutting rates to stave off greater economic damage, said Gabriel Doz, a portfolio strategist at PGIM Fixed Income. That monetary loosening will probably help company debt in general, he said.
“Over the next 12 months, even if we get a recession, it is fairly likely that excess returns are going to be positive from high yield to investment grade,” Doz said. A key question is when any recession begins and how long it will last, according to Doz. A shorter one, which is what he expects, would be better for corporate bonds.
Risk premiums on investment-grade notes in a shallow recession could widen to 180 basis points to 200 basis points before returning to their long-term averages, Doz said. US high-grade corporate bond spreads averaged 138 basis points on Monday, according to Bloomberg index data. Investors will likely have better opportunities than now to buy securities at cheaper valuations as the year progresses, Doz said.
Excess returns for high-grade corporate bonds were 0.18% for the month of April, bringing them to about 0.4% for the first four months of the year, according to Bloomberg index data. Excess returns for US high-yield bonds were around 1.7% for the period, the data show.
Outside of the US, investment-grade euro-denominated corporate bonds and Asian dollar peers have also outperformed so far this year, with both delivering excess returns of about 0.9% in 2023. Euro high-yield corporate debt has done even better.
One notable area that is losing money again for investors is Chinese junk debt, with renewed scares among property developers adding to double-digit losses in each of the two previous full years.
In the US, gains have come even after concerns about the US banking system surged to the front of investor attention in March after the failure of three lenders, including Silicon Valley Bank. Those worries have largely abated after a swift response from authorities.
But the turmoil isn’t completely gone: US regulators seized California’s First Republic Bank and JPMorgan Chase & Co. on Monday agreed to acquire the failed lender with government support.
Even so, metrics for companies’ credit quality look broadly strong. Debt is down relative to a measure of earnings compared with a peak in 2020. And despite the increase in borrowing costs, interest coverage metrics have improved, Citigroup Inc. strategist Daniel Sorid said in a phone interview.
“The market has lost a little bit of sight of the positive factors that stand behind the investment-grade credit sector given what we have seen in the banking sector,” Sorid said.
There are still reasons for investors to be cautious. A recent survey showed small businesses are more concerned about the outlook for credit, a measure that often translates to wider credit spreads. Corporate bankruptcy filings are climbing, and economic growth is slowing, even as inflation remains high. Some investors believe that corporate bonds aren’t paying enough attention to these warning signs.
“Our main scenario is later this year, rate hikes are really going to hit the economy,” said Pauline Chrystal, a fund manager at Kapstream Capital in Sydney. “In a recessionary scenario, we would expect Treasuries to rally and spreads to sell off and widen. Then you’d expect excess returns on credit to turn negative.”
But even if there’s economic weakness over the next 12 months, corporate bonds can perform relatively well, said T. Rowe’s Della Vedova. And for money managers that can pick credits well, there will probably be opportunities to earn even better returns.
“This year will be the year of the switch,” said Della Vedova. “We’ll get greater visibility on where we’re getting to on the macro side and therefore fundamentals will be key.”
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