Public Fixed Income

From Rates & Inflation to ESG: What’s Next for IG Credit?

January 2022 – 3 min read

Despite heightened risks, IG corporate bonds remain supported by an improving economy and robust corporate fundamentals.

Investment grade (IG) credit markets experienced increased volatility in the fourth quarter as investors faced a number of concerns, from the Omicron variant, to the U.S. Federal Reserve’s (Fed) announcement that it would taper its asset purchase program more quickly than anticipated. Still, there was good news to be found. Most companies reported positive earnings for the third quarter, with many beating expectations, while data also demonstrated that overall economic conditions remained fairly strong. Accordingly, IG corporate credit was up slightly at the end of the fourth quarter, returning 0.23%.1  Although spreads widened to finish the year at 92 basis points (bps), they still appear tight relative to historical levels.

Figure 1: IG Spreads Remain Tight Historicallyfrom-rates-and-chart1.jpg

Source: Barings. As of December 31, 2021.

Improving Fundamental Backdrop

Despite heightened risks facing the asset class, the fundamental backdrop remains solid. For many companies, revenue and EBITDA are above their pre-COVID levels. On a year-over-year basis, average revenue for the U.S. IG corporate universe was up 12%, and EBITDA had increased by almost 19%.2 Company margins have also improved. While there is some concern about the impact inflation will have, companies have generally been able to pass through those higher costs to customers—albeit with some dispersion across companies and sectors. At the same time, IG issuers across the board are continuing to pay down debt. After peaking at 3.3x in the third quarter of 2020, gross leverage returned to 2.9x in the third quarter of 2021—the same level seen at year-end 2019.3 

From a technical standpoint, robust new issuance early in the quarter continued to test the depth of buyer demand, which remained strong, before issuance slowed in the final weeks of the year. After having been positive for the majority of the year, fund flows were more mixed toward the end of 2021. However, with rate rises on the horizon this year, we will likely see a return of foreign demand back into U.S. corporate credit.

Energy Companies, EMD & ESG Bonds

Given the positive fundamental backdrop, we expect to continue seeing select opportunities emerge across key areas. One area in particular is in companies that are upgraded from high yield to investment grade. After a number of companies were downgraded last year following the onset of the pandemic, some of them have taken material steps to lower their leverage, and now look poised to make the transition back. We expect to see more of these so-called “rising stars” emerge in the coming months.

We also see value in the energy and commodity space, where many companies have benefitted from improved margins on the back of higher commodity prices. Commodity companies have also been very disciplined with their capital expenditures, which have fallen in recent months. On the other hand, capital expenditures for non-commodity companies have actually risen by 8%—which suggests that these companies are compensating for wage inflation and goods shortages.4 We also continue to favor the financials sector. We see opportunities within the insurance industry, particularly with life insurance and property & casualty companies, as well as in banks, which we believe are in good shape financially. 

In today’s low-yielding environment, and with rate rises expected this year, there are also potential benefits to looking beyond traditional IG corporate bonds. For example, collateralized loan obligations (CLOs) provide built-in protection from interest rate risk by virtue of their floating rate coupons, in addition to diversification benefits and strong structural protections. We are also seeing select opportunities in the emerging markets (EM) debt space, which is shorter in duration than developed market corporates and tends to trade wider given the idiosyncratic risks that exist across the EM landscape. 

Elsewhere, we believe ESG-labeled bond issuance will continue to grow from 2021’s watershed levels, and could exceed $1.3 trillion this year.5 Given that environmental, social and governance metrics tend to be widely available and fairly comprehensive for IG corporates, we expect to see an increase in investment grade ESG bond supply as well. As ESG bond issuance continues to increase, managers that fully integrate ESG analysis into their investment process, and are able to show ESG reporting at a portfolio level, will likely be at an advantage.

Figure 2: ESG Bond Issuance May Reach $1 Trillion in 2022from-rates-and-chart2.jpg

Source: Climate Bonds Initiative, Unicredit.

Looking Ahead

As we look ahead to the coming months, rates certainly remain top of mind. While this may cause short-term pain for IG corporates, higher rates in the longer-term would not be an entirely unwelcome event. In a yield-starved world, and with IG spreads hovering around historically tight levels, some large institutional investors have been forced to consider allocations to lower-rated, higher-yielding asset classes. Higher rates, and a widening of spreads toward more average levels, could effectively bring some of that demand back. 

Against the backdrop, we believe there are benefits to short-duration strategies, as well as multi credit strategies that can invest across the entire IG universe. Multi credit strategies are benchmark agnostic, meaning managers have the flexibility to pursue the best global relative value across asset classes, sectors and geographies—resulting in a diversified approach to credit that can potentially deliver more attractive risk-adjusted returns over time.

1. Source: Bloomberg Barclays. As of December 31, 2021.
2. Source: J.P. Morgan.
3. Source: J.P. Morgan. As of December 10, 2021.
4. Source: J.P. Morgan. As of December 2021.
5. Source: Climate Bonds Initiative, Unicredit.

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.