EN Canada

IG Credit: Can the Strong Performance Continue?

January 2021 - 4 min read

After a rollercoaster year, IG corporate credit ended on a high note. But all eyes are on the months ahead, and whether we could see a reversal of some of the trends that buoyed the asset class in 2020.

Despite the historic events that occurred in 2020, investment grade (IG) credit ended the year in strong positive territory, benefitting from lower interest rates as well as a flight to quality amid heightened volatility. IG corporate bonds delivered a total return of nearly 10% through year-end as investors—thanks to monetary support and the release of the COVID vaccine—largely shrugged off concerns around rising virus cases and the possibility of additional consumer restrictions. Corporate spreads continued to tighten during the fourth quarter to finish the year at 96 basis points (bps), very close to where they started, despite peaking at 393 bps in March 2020.1
 

Figure 1: IG SPREADS HAVE EXPERIENCED A STRONG RECOVERY

Source: Barings. As of December 31, 2020.


Indeed, with the prospect of many Americans being vaccinated during the first half of 2021, investors in dollar-denominated corporate credit appear to have set their sights on the months and year ahead.
 

Positives and Negatives

If all goes to plan with the vaccine, there is a good chance the economy could meaningfully reopen during the second half of 2021, and the fundamental picture for most companies could improve accordingly. Corporate leverage, while at all-time highs, has remained lower than initially feared—and a significant portion of the debt that companies have raised is sitting as cash on their balance sheets, meaning net leverage, in particular, has risen less substantially. Going forward, if companies are prudent, and use the cash on their balance sheets to pay down debt they no longer need, we expect leverage to trend toward more normal levels.
 

FIGURE 2: 12-MONTH GROWTH IN EBITDA, TOTAL DEBT & NET DEBT

Source: J.P. Morgan. As of September 30, 2020.


From a technical standpoint, as companies bolstered liquidity after the onset of the pandemic, credit issuance skyrocketed to more than $2 trillion ($1 trillion net)2 as companies capitalized on the government support. Despite this surge, the heavy supply was met with strong demand, which was easily absorbed by the market. The market’s ability to digest this large supply was due in large part to increased demand from overseas investors, as hedging costs improved meaningfully and the amount of negative yielding debt around the globe rose significantly—which by some estimates is upward of $18 trillion.3

With record levels of cash on company balance sheets, and the prospect of a recovery on the horizon, supply forecasts for 2021 are significantly lower. While we expect gross issuance to fall somewhere between $1.2 and $1.3 trillion, net issuance could fall further below historical averages, to as low as $300 billion—which, in our view, would remain supportive of spreads.4
 

Potential Reversal

On the negative side, the second half of the year could bring a reversal of some of the supportive trends we saw in 2020. For instance, as the economy opens back up, investors that gravitated toward IG as somewhat of a safe haven could begin allocating away—and toward higher-yielding or riskier asset classes. An improved economy could also reduce the perceived safety net provided by the U.S. Federal Reserve (Fed). Ultimately, this could lead to underperformance and spread widening, particularly in the lower-rated parts of the IG market. 

Interest rates are also top of mind for many IG investors. Although the Fed has made clear its intention to keep interest rates low in the near term, additional stimulus and an improvement in the economy could lead to rising expectations around an increase in rates. At a high level, rising rates are challenging for IG corporate credit, and would likely lead to negative total returns for much of the asset class, particularly if spreads remain range-bound. This in turn could potentially drive retail flows out of IG bond funds—although it is worth noting that the retail buyer base is a relatively small component of the IG market. 

The picture is slightly more nuanced, however, given that IG credit has different and multiple buyer bases—and to that end, there are also potential positives that could come out of an increase in rates. For instance, if rates reset to a higher level, the resulting incremental yield could present a potentially compelling opportunity for investors with long-dated liabilities, such as insurance companies and pension funds. If spreads remain stable, this could ultimately lead to a meaningful push back into IG corporate credit.
 

Uncovering Opportunities

Given the supportive fundamental and technical pictures, spreads could very well tighten this year as many forecasts suggest. In this environment, one way to take advantage of tightening spreads is to buy higher-beta credits that have not yet recovered. In the IG corporate space, for instance, we continue to see value in BBBs with solid fundamentals that look well-positioned to weather an extended period of COVID-related uncertainty. 

There are also potential benefits to reducing duration and moving up in quality. Outside of IG corporate bonds, for instance, higher-rated segments of the asset-backed securities (ABS) market, such as FFELP student loans, continue to look well-positioned—as do parts of the commercial mortgage-backed securities (CMBS) market, which are less sensitive to the path of the virus, such as warehouses and data centers. Collateralized loan obligations (CLOs) may also offer potential benefits going forward, in our view, particularly the AA and A parts of the capital structure. 

As we look ahead to the coming months, it is worth reiterating that questions remain around the deployment and acceptance of the vaccine. Although we believe there is room for optimism, we are not necessarily out of the woods yet. In this environment, a credit-by-credit approach remains critical—not only to capturing upside and identifying companies that are equipped to weather near-term challenges, but also to avoiding those that may face greater difficulties down the road.
 

1 Source: Bloomberg Barclays U.S. Corporate Index. As of December 31, 2020.
2, 3, 4 Source: Bloomberg Barclays Indices. As of December 31, 2020.

Any forecasts in this material are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Investment involves risk. The value of any investments and any income generated may go down as well as up and is not guaranteed by Barings or any other person. PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Read More Less

Any investment results, portfolio compositions and or examples set forth in this material are provided for illustrative purposes only and are not indicative of any future investment results, future portfolio composition or investments. The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this material No representation is made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency exchange rates may affect the value of investments. Prospective investors should read the offering documents, if applicable, for the details and specific risk factors of any Fund/Strategy discussed in this material.

Barings is the brand name for the worldwide asset management and associated businesses of Barings LLC and its global affiliates. Barings Securities LLC, Barings (U.K.) Limited, Barings Global Advisers Limited, Barings Australia Pty Ltd, Barings Japan Limited, Baring Asset Management Limited, Baring International Investment Limited, Baring Fund Managers Limited, Baring International Fund Managers (Ireland) Limited, Baring Asset Management (Asia) Limited, Baring SICE (Taiwan) Limited, Baring Asset Management Switzerland Sarl, and Baring Asset Management Korea Limited each are affiliated financial service companies owned by Barings LLC (each, individually, an “Affiliate”).

NO OFFER: The material is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service in any jurisdiction. The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This material is not, and must not be treated as, investment advice, an investment recommendation, investment research, or a recommendation about the suitability or appropriateness of any security, commodity, investment, or particular investment strategy, and must not be construed as a projection or prediction.

Unless otherwise mentioned, the views contained in this material are those of Barings. These views are made in good faith in relation to the facts known at the time of preparation and are subject to change without notice. Individual portfolio management teams may hold different views than the views expressed herein and may make different investment decisions for different clients. Parts of this material may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this material is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information.

Any service, security, investment or product outlined in this material may not be suitable for a prospective investor or available in their jurisdiction. Copyright in this material is owned by Barings. Information in this material may be used for your own personal use, but may not be altered, reproduced or distributed without Barings’ consent.

21-1466973

X

We use cookies on our website to provide you with the best experience. By proceeding to our site you agree to our Cookies Notice and our site Terms and Conditions.