Public Fixed Income

IG Credit: Well-positioned in a Challenging Environment

January, 2023 – 3 min read

In a potential recessionary environment, robust company balance sheets and normalizing yield levels are creating a compelling case for IG corporate credit.

Despite fears of a looming recession remaining front and center for investors, and against a backdrop of elevated inflation and rising rates, investment grade (IG) corporate bonds are starting to look increasingly attractive, for a number of reasons. For one, language from the U.S. Federal Reserve (Fed) in the fourth quarter pivoted toward a potential slowing pace of rate hikes, while U.S. inflation in November rose less than expected—resulting in a sentiment shift toward risk-on. Second, higher interest rates have not eroded the overall fundamental backdrop for IG corporates—and in fact many companies have stronger credit profiles today than before the pandemic. At the same time, given the upward move in yields, the return potential for fixed income is much more appealing than it has been for the last several years, suggesting there may be a cyclical rotation back into public fixed income. Against this backdrop, now may be a good time to consider IG credit.

Strong Fundamentals, Supportive Technicals

From a fundamental standpoint, the picture for IG corporates remains solid. Revenues and EBITDA look healthy after rising 18.1% and 19.8% year-over-year, respectively.1 Leverage levels have also continued to decline, and are currently at the lowest levels since 2016, while interest coverage has improved on both a quarterly and an annual basis. These factors reflect the fact that companies are being fairly conservative in managing their balance sheets and suggest that IG corporates are heading into a particularly challenging period from a position of strength. That said, profit margins may decline slightly going forward, given the ongoing impact of higher labor and energy costs, as well as the effect of currency changes amid a stronger U.S. dollar.

Figure 1: IG Corporate Fundamentals Remain Strong

ig-credit-well-positioned-chart2.jpgSource: J.P. Morgan. As of September 30, 2022.

In terms of technicals, given the negative total returns during the year, around $150 million of flows exited the asset class in 2022.2 However, on a positive note, higher rates kept new issue levels lower-than-expected at around $1.4 trillion—down from $1.7 trillion in 2021 and $2.1 trillion in 2020. Lower supply has indeed provided technical support to the IG asset class, and with forecasts calling for roughly $1.2 trillion in new issuance in 2023, this positive technical is likely to continue to support the asset class.3

Figure 2: Low Issuance Providing Technical Support

ig-credit-well-positioned-chart1.jpgSource: Barclays. As of December 31, 2022.

Upgrades May (Counterintuitively) Outpace Downgrades

Given the strong fundamental backdrop and potentially supportive technicals, we expect to continue seeing select opportunities emerge going forward. One area in particular is in sectors where spreads have widened beyond what fundamentals would suggest, such as financials. More specifically, spreads on banks widened significantly in 2022, largely driven by technical factors, and they remain wide relative to recent history. From a liquidity and leverage standpoint, banks look particularly well-positioned heading into a slowdown. We also see value in select, less-liquid companies in the financial sector such as life insurers and REITs—these companies underperformed amid last year’s volatility, but their strong credit profiles should support performance going forward.

We also see value in companies that look poised to see an upward migration in credit ratings, particularly those transitioning from high yield to IG, or so-called “rising stars.” Last year, there was around $50 billion of rising stars versus under $10 billion of fallen angels (IG companies that are downgraded to high yield).4 Despite the recessionary headwinds on the horizon, we expect—somewhat counterintuitively—to see more rising stars than fallen angels in the year ahead. This is largely due to the fact that many companies, after being downgraded during the pandemic, took material steps to lower their leverage. As a result, these companies have stronger credit profiles today and look poised to make a transition back to IG—including some larger companies like Occidental and Ford.

Public Fixed Income Back in Favor

As we look ahead to the coming months, recessionary concerns and the impact of higher prices on corporate earnings remain top of mind. We continue to monitor which sectors are seeing ongoing margin deterioration and pressures on P&L accounts. Against this backdrop, and if we do enter a recession, we expect spreads may experience some widening, though it’s unlikely to be substantial. Part of this is due to IG corporates’ strong balance sheets and healthy fundamentals, putting them in a good position to face economic headwinds.

At the same time, the yield environment today is radically different compared to the past decade, when accommodative central bank policy and low rates drove yields on IG corporates down—below 2%, in some cases.5 As large investors struggled to meet their target returns, there was a shift away from fixed income and into asset classes such as equities and private credit in search of higher yields. Today, however, sentiment seems to be shifting once again. With current yields on IG corporates ranging between 5-6%,6 the total return potential for IG corporates is much more attractive than it has been over the last several years—making a strong case for a cyclical shift back into the asset class going forward. Of course, given the headwinds on the horizon, a bottom-up approach to credit selection remains crucial to navigating the risks at hand and identifying the issuers that are well-positioned in this environment.

1. Source: J.P. Morgan. As of September 30, 2022.
2. Source: J.P. Morgan, Bloomberg.
3. Source: J.P. Morgan, Bloomberg. As of December 31, 2022.
4. Source: J.P. Morgan, Bloomberg.
5. Source: J.P. Morgan, Bloomberg.
6. Source: Bloomberg U.S. Corporate Index. As of December 31, 2022.

23-2662397

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.

Related Viewpoints