Public Fixed Income

IG Credit: Strong Fundamentals, But Inflationary Pressures Grow

October 2022 – 4 min read

Current yield and spread levels, coupled with companies’ durable credit profiles, suggest that IG corporate credit continues to look attractive—but a number of risks remain on the horizon.

Rising costs began to pare down investment grade (IG) corporate margins from historical highs in the third quarter, while a second consecutive 75 basis points (bps) interest rate hike reaffirmed the U.S. Federal Reserve’s (Fed) aggressive stance on fighting inflation. The ongoing war in Ukraine, lingering supply chain issues and growing labor costs further weighed on sentiment, fueling fears of an economic “hard landing” or recession. At the same time, the U.S. dollar strengthened, further complicating profit outlooks for IG companies. All of these factors contributed to the growing risk-off tone in the market, which led to a negative total return for IG corporate bonds, with the asset class down -5.06% at quarter-end.1 On a sector basis, financials underperformed industrials, while utilities outperformed, in keeping with the rotation into defensive sectors.

While spreads tightened marginally during the quarter, they remain wide relative to five and 10-year averages. At the same time, yields have climbed rapidly—the IG corporate index is currently yielding around 5.69%, mostly driven by higher rates.2 These current yield and spread levels, coupled with issuers’ durable credit profiles, suggest that IG corporate credit continues to look attractive from a valuation perspective relative to the past 12–24 months.

Figure 1: IG Valuations Look Potentially Attractive

igcredit-strong-fundmentals-chart1.jpgSource: Bloomberg Barclays. As of September 30, 2022.

Inflation Woes Test Fundamentals

Revenues and earnings began the third quarter at relative strength with strong year-over-year growth, though early indications point to some erosion in fundamentals due to inflation. Profit margins have declined from previous quarters due to higher energy and labor costs, as well as the effect of currency changes amid a strengthening U.S. dollar. On the positive side, leverage levels continued to tick down. As corporate debt levels have decreased, interest expenses have come down as well. At the same time, interest coverage has increased, helping maintain accumulated balance sheet strength.

Technicals Remain Mixed

The upward rate trend and subsequent negative returns have resulted in further outflows from the asset class, despite several weeks of inflows during the summer. However, higher rates have also led to lighter-than-expected supply as companies delay issuing new bonds, adding some technical support. The decline in anticipated new issues should remain supportive of the asset class through the remainder of the year, and demonstrates the ability of IG companies to manage through the tightening cycle without increasing leverage.

Interestingly, despite the recent spike in yields, demand from yield-seeking overseas investors has been less than expected, largely due to high currency hedging costs. That said, certain non-hedged vehicles, such as U.S. dollar-denominated products, continue to see some demand, particularly from buyers in Asia.

Wider Spreads Leading to Opportunities

As spreads have remained wide relative to recent history—particularly the period of post-COVID spread compression that continued through 2021—we are finding potentially attractive buying opportunities in several areas of the market where spreads have widened beyond what fundamentals would suggest. From a sector perspective, we continue to find value in financials, a sector that has recently underperformed. New issues, some with sizeable concessions, from larger U.S. money center banks, regional banks, and banks in Asia and Europe have provided compelling opportunities, particularly in shorter-duration credits. We also see value in select, less-liquid companies in the financial sector—such as business development corporations, air lessors, asset managers and smaller insurance companies—that have fallen out of favor amid recent volatility, despite having strong credit profiles that should support performance going forward. We also continue to find opportunities in the energy sector. Cash flows remain solid even as oil and natural gas prices have moderated from their highs. With a number of existing bonds expected to be called or tendered soon, the sector continues to exhibit compelling new issue supply/demand dynamics.

Outside of traditional IG corporate credits, spreads have widened on certain securitized products such as mortgage CRTs, creating the potential for significant spread pick-up. In particular, we see attractive opportunities in issues with solid cash flows and high credit ratings, especially as consumer balance sheets have remained healthy. High-rated AAA CLOs also offer the potential for a significant spread pick-up, with the added benefit of robust structures that have helped the asset class weather past periods of volatility well. Consistent with opportunities in IG corporates, shorter duration assets look more appealing amid widening spreads and economic uncertainties.

What’s Next

The risks that drove investor sentiment earlier this year remain in play today. The Russia-Ukraine war continues to cause economic and political uncertainty. The Fed’s hard stance on inflation has increased fears that rate tightening will lead to a recession or to stagflation—an inflationary environment paired with weak economic growth. We continue to watch any indication of ebbing inflation and a possible softening of the Fed’s hawkish policies that could reduce the heightened rate volatility. Additionally, we are monitoring corporate earnings for signs that the economy has reached recessionary inflection points.

Earnings warnings from bellwether companies FedEx and Ford indicate that recessionary fears and the impacts of inflation will continue to put pressure on corporate revenues, supply chains and consumer sentiment, which could meaningfully impact demand. Against this backdrop, we anticipate spreads may have further room to widen, even if corporate fundamentals remain largely intact. While corporate debt has held up well and outperformed equity, a prolonged decline in equities will result in a difficult environment for corporate fixed income. Negative performance resulting in further outflows may create additional technical headwinds.

In this environment, bottom-up credit selection remains key, not only to identifying and capitalizing on opportunities, but also to managing—and mitigating—the myriad of current risks that could impact the asset class going forward.

1. Source: Bloomberg Barclays. As of September 30, 2022.
2. Source: Bloomberg. As of September 30, 2022.

22-2461526

Charles Sanford

Head of Investment Grade Credit

Stephen Ehrenberg

CFA, Managing Director

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.

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.