IG Credit: Higher Rates on the Horizon
Will rates march higher from here? Investors would need a crystal ball to know for sure, but either way, the risk of higher rates and the potential headwind they represent are at the forefront of the worries currently facing investment grade (IG) corporate credit investors. As the U.S. Federal Reserve signaled it would begin tapering its asset-purchase program in November—and suggested interest rate hikes could come in mid-2022—U.S. Treasury yields rose toward the end of the third quarter. Accordingly, IG corporate bonds turned negative, returning -1.27%.1 From a sector perspective, financials proved to be the most defensive, particularly the life and property & casualty subsectors. Energy companies, namely exploration & production and pipeline companies, also fared well.
While negative total returns can lead to retail flows out of IG bond funds, we have yet to see this trend materialize. Indeed, fund flows have remained positive across the board, and slightly skewed toward the shorter-duration part of the curve. Why? Partly because higher rates aren’t necessarily all bad news for investors. With low and negatively yielding assets still the norm, especially for developed market government bonds, investors remain starved for yield. Higher rates that bolster yields for high-quality corporate bonds, therefore, are likely to drive inflows to the asset class, even if current holders may take a hit from the rate adjustment. Part of this is a reversion trade as investors that moved down the credit spectrum in search of yield begin to retrace their steps.
Supportive Technicals, Strong Fundamentals
Despite the higher trajectory of rates, as well as headline risks related to the Delta variant and Chinese regulatory crackdowns, corporate spreads ended the quarter flat—partly a result of the strong fundamental and technical backdrop. Although elevated new issuance continues to test corporate markets, it has moderated somewhat since 2020’s record-breaking year, reaching $1.4 trillion as of quarter-end.2 Positively, the heavy supply continues to be met with strong demand, particularly from overseas investors in Asia, and fairly easily absorbed by the market. From a fundamental perspective, corporate leverage has continued to improve, returning in many cases to pre-pandemic levels. Additionally, many companies have continued to take a disciplined approach to deploying the cash on their balance sheets, with most using it to pay down debt.
FIGURE 1: IG SPREADS REMAINED STABLE IN THE THIRD QUARTER
Source: Barings. As of September 30, 2021.
Rising Stars, EM Debt
There may not be much room for further spread tightening from here, particularly if economic indicators begin to point more clearly to slower economic growth. On the bright side, however, we expect the fundamental backdrop and continued post-pandemic recovery to remain supportive of corporate credit, with select opportunities likely to emerge across a few key areas.
One area where we continue to look for opportunities is in so-called “rising stars”, or companies that are upgraded from high yield to investment grade. Given the more favorable cost of capital and better access to capital markets, there is an incentive for companies to either remain in, or get upgraded to, the IG universe. For instance, after a number of companies were downgraded last year following the onset of COVID, a handful—such as EQT Corporation and Kraft Heinz—have taken material steps to lower their leverage, and now look poised to make the transition back. There are also companies that are not fallen angels but, due to their improving credit metrics, could become rising stars. Netflix is one example.
Given current spread levels, and with higher rates potentially on the horizon, we also see value in shorter-duration and floating rate strategies. Collateralized loan obligations (CLOs), for instance, can help lower sensitivity to interest rate moves given their floating rate coupons. We are also finding opportunities in investment grade-rated EM corporate debt, which tends to be shorter in duration than developed market corporates and often offers a potential spread premium. We saw this recently as volatility in the market escalated on the back of concerns that Chinese property developer Evergrande may default on its debt. While we do not believe the events will significantly affect the U.S. market, the uncertainty caused the spread differential between IG corporates and EM corporate debt to widen by roughly 20–30 basis points (bps), over their developed market peers.3
Flexibility is Key
In the current environment, we believe there are material benefits to having broad exposure to the investment grade universe. A multi credit approach can be particularly beneficial, in that it provides a single point of access to a broad range of investment opportunities, from IG corporates and EM debt, to collateralized loan obligations and asset backed securities. Unlike traditional fixed income strategies, multi credit strategies are benchmark agnostic, meaning managers are not required to adhere to a benchmark when constructing the portfolio—and therefore have the flexibility to pursue the best global relative value across asset classes, sectors and geographies. For this reason, in addition to offering enhanced portfolio diversification, multi credit strategies can potentially lead to more attractive risk-adjusted returns versus traditional or single-sector strategies over time.
1. Source: Bloomberg Barclays. As of September 30, 2021.
2. Source: Bloomberg Barclays. As of September 30, 2021.
3. Source: J.P. Morgan. As of September 20, 2021.