Corporate credit has failed to live up to lofty expectations of double-digit returns so far this year, fueling a string of bearish bets into the second half of 2023.
Global corporate debt returns have advanced just 3% after aggressive interest-rate hikes from policymakers at the Federal Reserve and their peers around the world. That’s a heavy blow to money managers that were banking on gains of more than 10% for high-grade bonds in 2023, predicted by the likes of Bank of America Corp., which has since revised its year-end target down to about 8%.
As traders brace for more rate hikes from the Bank of England, European Central Bank, and the Fed, it seems unlikely that returns will stage a massive turnaround any time soon.
“Credit in general is going to underperform what most people expected,” said John Luke Tyner, a fixed-income portfolio manager at Aptus Capital Advisors. “It’s priced for absolute perfection and absolute disinflation which is not happening very quickly.”
This year might be tougher than the market thinks. Softening US consumer spending data indicates that a sharp economic slowdown is looming — which risk premiums may not be reflecting. Michael Contopoulos, director of fixed income at Richard Bernstein Advisors, doesn’t see spreads in either the US or Europe as compensating investors for recession risk.
“Some will say that the investment-grade market is a good place to be — I mean, that’s high quality, certainly — but we don’t think corporate credit is actually where you want to be positioned at the moment,” he said in a Bloomberg Television interview.
Contopoulos sees more opportunities in European corporate credit compared to the US, where risk premiums would need to be at least 30 to 60 basis points wider than current levels depending on the economy’s trajectory, he said in a separate phone interview.
Average spreads on US investment-grade bonds traded at 123 basis points on July 5, after spiking to 163 basis points in March during the global banking sector turmoil, while the same measure in Europe traded at about 158 basis points following a high of 200 basis points in March.
As such, Contopoulos is buying long-duration Treasuries and high-quality, short-dated floating-rate debt like AAA collateralized loan obligations. The Palmer Square CLO Debt index has returned 7.3% so far in 2023.
Other bears like Aptus’s Tyner say the “pain trade” this year would combine higher rates and wider spreads. He sees more opportunities in other areas of fixed-income like municipal debt, which has gained 2.7% so far this year.
Still, fund managers in Bank of America’s May survey were the most bullish on bonds since 2009, and in the latest June survey were the most overweight high-grade over junk bonds in the last eight years. Meanwhile, average yields of more than 5% are drawing demand from investors looking to park cash in relatively safe, high-yielding assets as the global economy braces for an impending recession.
“Investors are still worried about a potential slowdown in growth or a recession in 2024,” said BofA strategist Yuri Seliger in a phone interview. “One way to position for that is to be underweight to things that are sensitive to recession risk — which would be stocks and high-yield — and instead put your money into more defensive asset classes which would be bonds and specifically investment-grade as it gives you a little bit more yield than Treasuries.”
Issuance over the course of the summer will also likely slow due to seasonal trends, which could help boost returns in the near term, according to some market watchers.
“Investment-grade valuations on a relative basis look attractive to us,” said Meghan Robson, head of US credit strategy at BNP Paribas, in a phone interview. “It is more likely to have stable demand as investors like less risky assets heading into a slowdown.” Robson likes longer duration in particular and is more bearish on leveraged credit.
Hiking Higher
The Bank of England in June unexpectedly raised its benchmark interest rate by a half percentage point to the highest level in 15 years. The European Central Bank also took its rate to the highest level since 2008 after bumping it up by a quarter-point in May, while indicating more hikes are coming this year. Federal Reserve Chair Jerome Powell meanwhile signaled that two more rate increases could be on the way after hikes were halted in June for the first time in 15 months.
“There is definitely more work to be done by the ECB and Bank of England,” said Richard Zogheb, head of global debt capital markets at Citigroup Inc. “Inflation is so much higher there than in the US and it feels like those central banks are behind the Fed.”
Zogheb likes US investment-grade credit with an expectation that rates will trend lower over the next 12 to 18 months.
European economies, households, and enterprises, meanwhile, continue to demonstrate resilience amid tightening in financial conditions, according to Paul Watters, head of European corporate research at S&P Global Ratings.
“This resilience also reflects that much of the real impact of the rise in interest rates has still to percolate through,” he wrote in a report.
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