Public Fixed Income

Investment Grade Credit: Higher Rates Aren’t All Bad

April 2022 – 3 min read

The Russia-Ukraine conflict and rising interest rates have affected all bond markets, but opportunities remain among the investment grade universe.

Russia’s invasion of Ukraine, higher inflation and rising rates were the major developments affecting financial markets in the first quarter. Investment grade (IG) corporates were down as a result, returning -7.69% for the quarter, although performance varied by sector.1 Aircraft lessors, for instance, have been directly affected by the Russia-Ukraine war, given that many companies that leased planes to Russian firms, as a result of sanctions put in place, can no longer accept payments from those firms. Financials also underperformed, partly because of the negative impact of the war on Yankee banks, or foreign (typically European) banks that do most of their business in the U.S. On the positive side, higher commodity prices have provided a boost to energy companies, helping accelerate their efforts to reduce their debt levels.

In terms of credit spreads, there has been significant movement in a very short period. At the end of the second quarter of 2021, spreads on investment grade bonds had reached 77 basis points (bps), which are historically tight levels particularly when adjusted for credit quality and duration profile. By the end of March, spreads had widened to 108 bps, having peaked at 135 bps. Spreads ended the quarter more in line with historical averages (Figure 1).

Figure 1: Credit Spreads Return to More Normal Levelsinvestment-grade-credit-higher-chart1.jpg

Source: Barings. As of March 31, 2022.

Return of Overseas Buyers

From a fundamental perspective investment grade companies entered this challenging period from a position of financial strength. Revenues and EBITDA, for many companies, have returned to or exceeded pre-COVID levels. Leverage has continued to decline as issuers across the board take steps to pay down debt. After peaking at 3.3x in the third quarter of 2020, gross leverage had returned to 2.9x by the end of 2021—comparable to 2019 levels.2 At the same time, company margins continue to improve. While higher inflation certainly poses a risk, companies have generally been able to pass higher costs through to their customer.

From a technical standpoint, following two very strong years of new issuance, expectations were for a return to more normal levels. While issuance has moderated to some extent, it remains elevated relative to history, reaching $458.7 billion as of quarter-end.3 Overall, the supply in the market has been absorbed well. Although fund flows have turned negative after being positive through almost all of last year, higher rates have led to stronger demand from overseas buyers, particularly at the longer end of the curve. As rates continue to move higher—and with the widening of spreads to more normal levels—this push back in to the asset class should continue as investors like insurers and pension funds seek to capitalize on the resulting incremental yield.

Areas of Opportunity

We are currently finding opportunities in short-duration bonds. These bonds have lower duration risk, which means the price of the bond is fundamentally less sensitive to changes in interest rates compared to longer-dated bonds. Immediately following the U.S. Federal Reserve’s plan to raise its benchmark fed-funds rate, there was some inversion of the yield curve as shorter-duration bonds became more expensive. Prices came down in subsequent weeks, however, and we are currently finding attractive pricing with some of the new issuance of short-duration bonds in particular.

We also think one-off opportunities can be found in areas where the market may have overreacted to the impact of the Russia-Ukraine war. For example, while aircraft lessors have lost business, many of these firms, such as AerCap, have very strong business models and were able to get through the pandemic successfully, which arguably had a greater impact on their business. Certain short-duration bonds from Yankee banks also look attractive, particularly those with little direct exposure to Russia or Ukraine. In some cases, these banks have been unfairly lumped together with other European banks that are more directly exposed to the conflict, and prices look attractive as a result.

Rising stars, or companies that look poised to migrate from high yield to investment grade, continue to present interesting opportunities as well. Much of this opportunity stems from the large number of companies that were downgraded from investment grade as the pandemic took hold. While we have already seen a handful of companies make the return trip to IG, there are many more that appear to be on the verge of an upgrade. Energy companies in particular stand out. In addition to benefitting from higher oil and gas prices, many have taken material steps to lower leverage in recent years.

Risks We’re Monitoring

The Russia-Ukraine war is clearly a major risk to monitor in the months ahead. Fed policy is another factor to watch. If the Fed gets too aggressive in its efforts to address inflation, it could end up tightening monetary policy to a degree that slows down the economy and potentially triggers a recession. There also appears to be an increased risk that we could see stagflation—an inflationary environment paired with weak economic growth. While companies up until now have been able to pass higher costs on to consumers, there are questions around how much longer that can continue—particularly if higher costs for food and fuel begin to chip away at demand. In this environment, flexibility is key, and there can be benefits to considering multi credit strategies that can invest across the entire IG universe. Because they are benchmark agnostic, multi credit strategies position managers to pursue the best global relative value opportunities as they arise and potentially deliver more attractive risk-adjusted returns over time.

1. Source: Bloomberg Barclays. As of March 31, 2022.
2. Source: J.P. Morgan. As of December 31, 2021.
3. Source: Bloomberg Barclays. As of March 31, 2022.

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.