USA Inc. est riche (et gratifiant)

A year of the (corporate) bond 

A positive view on investment-grade and high-yield credit is one of my core themes. It has been a successful one. Returns have been strong, consistent with the ‘year of the bond’ mantra from 2023. Despite the volatility seen in interest rate expectations, credit index returns have been rewarding. For US investment grade, the one-year total return as of 3 March was 6.75% with the BBB-rated cohort delivering 7.8%. European investment-grade indices delivered 7.5% for the whole market and 8.0% for the BBB-rated part. Sterling corporate bond returns have been similar.

Returns have been even stronger, as one would imagine, in high yield markets. The one-year total return for US high yield has been 11% and for Europe, 10.3%. Investors willing to have exposure to the highest credit risk segment in the US market, CCC-rated bonds, would have received equity-like total returns of 15%. So even though long duration in rates and betting on interest rate cuts have not been very rewarding strategies, being overweight credit has. Almost all categories have seen positive excess returns (compared to government bonds) over the last 12 months.

Total returns have been a little weaker since the start of 2024 as a result of the back-up in underlying bond yields. Short duration investment-grade, high-yield and leveraged credit have, however, delivered positive returns so far. The recent stabilisation and move lower in bond yields should provide for positive returns in March.

Valuation concerns? 

The past year’s performance has been driven by income and positive price changes resulting from the tightening of credit spreads. Over the year, the average spread on the US investment grade index fell by 30 basis points (bp) - representing itself about two percentage points of return. Spreads across most credit asset classes have fallen steadily since the brief period of concern about US regional banks a year ago. In fact, since the peak of those worries, the change in spread has been 64bp for the US investment grade market and 75bp in Europe. This reduction in credit risk premium reflects the confidence investors have in high-grade companies, the strength of the US economy and general corporate profitability.

Now spreads are hovering around 100bp for US investment grade. In Europe spreads are typically measured against the swap curve and stand at 86bp. All-in yields are 5.4% for the US and 3.80% for Europe. The US stands out as more expensive when considering the current level of credit spread relative to its history –around the 12^th percentile of the distribution of spreads over the last 10 years. European investment grade stands at the 70^th percentile on the same metric. The picture is the same for high yield, with the US spread at 330bp compared to 405bp a year ago and 600bp during the middle of the Fed’s aggressive hiking cycle in 2022.

Solid state 

There’s a reason credit has got more expensive relative to government bonds. Investors like it. They like it because corporate balance sheets are strong, interest coverage is manageable despite higher yields and companies have a lot of cash, so their net interest burden is lower than in previous cycles. In other words, perceived risk is low. In addition, there is yield and this means income is helping drive, and more important, in total returns. For US investment grade, over the last year, income represented 4.5% of the total 6.75% total return. For high yield, the income component was almost 7%.

What are the risks? 

Spreads are back to where they were just before the pandemic after credit delivered strong returns in 2019. Borrowers have been conservative with their balance sheets since – there has been no leverage boom. Meanwhile, earnings growth has been strong. The fundamental story is still attractive, so what could go wrong for credit? I think we can rule out any further increases in interest rates in the US or Europe, so any underperformance would have to come from factors that could drive credit spreads wider.

Slower growth 

One risk is that economic growth slows more than it has so far, exposing weak and indebted sectors. While economists will argue whether the level of interest rates and overall financial conditions are tight, relative to some concept of neutral, it is unarguable that rates went up a long way in 2022 and 2023. Borrowers on fixed rates will have been cushioned from the impact to some extent, but there are plenty of consumer, credit card and auto liabilities that operate with floating rates. Credit card delinquency rates in the US have been rising since 2021 according to the Fed. Delinquency rates of more than 30 days on auto loans are currently at their highest levels since 2010. If growth slows and, importantly, unemployment begins to increase, some of these credit issues could receive more attention. However, the banking sector is well capitalised and these low-end consumer credit issues are unlikely to become a systematic risk. What may be more of an issue, albeit a slow moving one, is that some of the fundamental metrics supporting credit markets could deteriorate a little. Debt issuance has been running hot already in 2024, which means average interest costs are rising. The average coupon on the US investment grade market has moved up from 3.65% to 4.25% since mid-2022, and from 1.5% to 2.3% in Europe. These are sizeable moves and will put pressure on interest coverage ratios. But not enough to change the core view on credit, particularly as there is little evidence of a marked slowdown in growth, especially in the US.

Credit events 

There is always the chance of a credit event. Regional banks have been in the spotlight over the last year, largely because of their exposure to commercial real estate (CRE) and, particularly, the office building market. I discussed this with our real estate team and economists this week and we came to the conclusion that CRE is a problem, albeit one with limited scope. The impact on larger banks is negligible given the amount of provisioning set aside for credit issues. Still, another regional bank issue related to CRE could have a negative impact on investor sentiment and could force the Fed to re-introduce liquidity tools. A shock and a central bank response would likely mean wider spreads, at least for a while.

Risk-off 

Evidence of slower growth, a Fed reluctant to ease, sticky service sector inflation, some more bad news on commercial real estate and the uncertainties around what will happen after the US Presidential election could all contribute to a negative shift in risk appetite. Credit is quite expensive in the US. Equities are expensive too. Using consensus earnings estimates for 2025, the S&P 500 is trading on a multiple of 19 times. This is just below the recent peak of 20 times in 2021 when multiples expanded during the post-pandemic recovery. Few would be surprised if the stock market went through a period of adjustment, especially as much of the total return performance has been driven by a mere handful of technology stocks over the last year.

This week’s primaries confirmed that Donald Trump is very likely to be the Republican candidate in November’s US Presidential election and there will be a Biden versus Trump repeat. In 2020 it was uncomfortably close and that led to a sharp increase in political risk. Might we see another close race? If so, uncertainty over policy will increase – will there be any attempt to prevent the Federal debt-to-GDP ratio spiralling higher, will there be another round of trade sanctions with China, will monetary policy be compromised by appointments to the Fed? Investors need to think about these things, and it may be that a period of less exposure to risk becomes warranted.

But carry is strong 

All of the above are risks but, for now, they are not material enough to reverse positive momentum in markets. There is no recession, rates will probably come down in the second half of the year and companies are doing very well. Europe is weaker but lower rates should help, and the forecasts from the UK’s Office for Budgetary Responsibility, presented alongside this week’s fiscal Budget, are more positive. Any setback in markets should potentially be seen as an opportunity to invest (buy on dips). Given where yields are, carry will remain an important driver of total return in credit markets.

Hedging risk is relatively cheap. The Europe Crossover credit default swap index is trading below 300bp, its lowest since just before rates started to increase. The VIX equity volatility index is certainly off its lows but remains well below the levels it tends to reach when there is a market wobble. And there remain opportunities to diversify away from the US if there are concerns about valuations. The Euro Stoxx index has a current multiple (on 2025 expected earnings) of 12 times compared to the near 20 times for the US.

Better macro, fewer rate cuts 

There’s another quarter to go before the market is expecting rates to be cut in the US and Europe. We have time to assess how markets are likely to respond. If it is a gentle easing against a backdrop of positive global growth, then bond returns are likely to be close to current yield levels (mid-single digits) and equities can still deliver something close to expected earnings growth (low double digits). While some might clamour for more rapid rate cuts, the likelihood is that if that were to happen, the macro backdrop would be much worse and thus, much worse for credit and equities. A Fed having to ease in and around a contentious Presidential election campaign would not be a favourable investment climate. The rest of the year is going to be interesting, but for now, stay with credit.

(Performance data/data sources: Refinitiv DataStream, Bloomberg, as of 6 March 2024, unless otherwise stated). Past performance should not be seen as a guide to future returns.