Fixed income perspective – from the Investment Advisory Group

Executive summary

• Since July 5^th, investment grade (IG) and high yield (HY) credit spreads tightened (i.e., improved) dramatically to levels near their 10-year averages after mounting recession fears fueled a period of notable stress.
• U.S. credit spreads now appear overly sanguine given the aggressive, synchronized global monetary policy tightening and its lagged impact on economic activity.
• We view credit spreads’ sharp recovery as an opportunity to reduce exposure in U.S. corporate bonds, particularly for investors who have created sizeable overweight positions over the past few years in search of higher yields.
• In periods of slowing economic activity, total returns within fixed income tend to benefit from higher overall credit quality, either by shifting to higher rated corporate issuers or adding to high quality alternatives, such as U.S. government debt.

What happened

IG and HY corporate bond spreads, or the differential between each sector’s yields and U.S. Treasury yields of the same maturity, rose significantly throughout the first half of 2022. Credit spreads tend to widen in periods of growing economic concern and risk aversion among investors, with HY susceptible to far more dramatic widening than IG given its riskier characteristics. In the first half of the year, increasingly hawkish Federal Reserve (Fed) rhetoric, the most rapid sequential rate hikes in three decades, generationally high inflation, and softening economic data provided the catalysts.

More recently, spreads have returned to historically normal levels. Speculation that the Fed may soon decelerate its policy tightening, a tick down in inflation, and July’s strong unemployment report eased recessionary concerns and restored risk appetites. U.S. corporate bond funds have enjoyed a month straight of stable inflows.

Our take

Broadening inflationary pressures and strong labor data suggest the Fed will maintain its aggressive policy stance in the months ahead with additional rate hikes and balance sheet reductions. Furthermore, monetary policy works with a significant lag. The negative impact of the Fed’s current tightening cycle on the U.S. economy will continue to reveal itself well into next year via softer consumer demand and higher borrowing costs.

While a recession is not a foregone conclusion, the sheer size and pace of the Fed’s tightening is likely to weigh meaningfully on the economy and market sentiment. With each rate hike, the path for a soft landing grows increasingly narrow. With that in mind, we view the recent reprieve in credit spreads as an opportunity to reduce credit risk at relatively attractive valuations, particularly in HY.

Why now?

As the risk of deeper economic downturns mounts, credit spreads typically widen – sometimes very quickly – and can create periods of strong underperformance. This is especially true in HY corporate bonds, which carry a higher correlation to U.S. equities than IG corporates. Following their recent rallies, we believe current credit spreads fail to reflect the future drag that Fed policy is likely to create, even if a recession is ultimately avoided.

IG and HY credit spreads are significantly lower than previous periods of economic stress, such as in 2011 (Greece debt crisis, U.S. credit rating downgrade) and 2016 (previous Fed tightening cycle, global slowdown and oil supply glut). In particular, HY spreads are a far cry from those reached during the previous three recessions, which have averaged 1,369 (13.69%) basis points. Timing a tactical shift ahead of rapid spread widening is difficult, and economic uncertainty remains extremely elevated. Therefore, we would prefer a potentially early and proactive approach in increasing portfolio quality.

Additionally, instances of defaults among HY corporate issuers remain historically low at just 1.4% for the 12-month period through July. Many U.S. companies’ balance sheets swelled as a result of the Fed’s massive stimulus measures, resilient consumer demand through the pandemic, and large new debt issuance to raise defensive cash positions. However, corporate balance sheets are now showing early signs of deterioration. Although earnings have remained resilient, cash on hand has declined. At today’s much higher interest rates, issuing new debt to raise cash is far more costly than in the previous two years. Refinancing outstanding debt is a less economically feasible option for issuers that captured the low borrowing costs of the previous decade. The Fed’s rate increases and the end of the fiscal stimulus era have also tightened financial conditions significantly, which is set to continue. Therefore, we expect HY default rates to trend higher from historically low levels and push credit spreads higher.

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