Investment-grade bonds is in the sweet spot

A predicted economic slump is now expected to be shallower and shorter than previously feared. And yields are relatively high – the average yield of the Bloomberg Global Bonds index is 3.4%, versus 0.8% at the beginning of 2021! –, even after a rally in bonds sent yields tumbling in recent weeks (see the chart). That income, which is better than we have seen in a decade, is a terrific buffer to any price volatility that we could see…



This comes in the wake of a brutal period for bond markets. As central banks rolled back years of unprecedented stimulus injections and hiked rates in 2022 at the fastest pace since the 1970s, bond returns fell in their worst year in well over a decade. Investment-grade bonds, which typically have higher duration than their junk-rated peers, were hit hardest last year (they were down about 11%, compared with a 7% drop for high-yield bonds) by the sudden and aggressive increases in interest rates. The higher the duration, the more sensitive the bonds are to central bank actions.

Believe it or not, high-yield bonds (3.9%) are again outperforming investment-grade corporate bonds (2.1%) since the beginning of the new year despite rising concerns that the Federal Reserve’s aggressive monetary policy tightening will set off a recession (see the chart).

But just don’t expect it to last through 2023, as rating downgrades and defaults are likely to drive investors to the safety of high-grade debt.

• In the high-yield market, potential rating downgrades outweigh upgrades by a ratio of 2.1, compared with 0.72 for investment-grade debt, according to data compiled by Bloomberg.
• The outperformance of high-yield bonds should narrow as safe bonds should rally in anticipation of the US central bank’s shift to a slower pace of interest-rate increases - the Fed said in February it was hiking rates by a 0.25%, less than the 0.50% boost in December and the four jumbo-sized 0.75% hikes before then.
• Duration, a key gauge of how sensitive bond prices are to interest-rate moves, explains most of this forecast. The option-adjusted duration of the Bloomberg Corporate Bond index stands at about 7-9 years for investment-grade debt with a rating between “AA” and “BBB”. It is less than 4 years for the high-yield bonds (rating below “BB+”), meaning investment-grade bonds see a greater impact from interest-rate changes (see the chart). As the Fed moves closer to pausing, it will become less of a headwind for the investment-grade bonds, particularly if the economy slows enough that rate cuts don’t seem that far off.

• Indeed, in past years when the economy slowed or fell into recession, investment-grade returns mostly beat those on high-yield, according to annual data going back to early 1980s (see the chart). That is understandable. As corporate tilts into an earnings recession, better-rated companies should outperform, given they are better situated to handle a downturn than their high-risk peers. S&P Global Ratings estimates the default rate on non investment-grade corporate bonds could double to 3.75% by September 2023.

To be sure, if a Fed “pivot” (if the central bank opts for a more accommodating monetary policy) comes this year, risk assets including high-yield bonds will take off. Or if the Fed achieves a soft landing, that could bring about a major revival in high-yield bonds, too. Yet both scenarios look too optimistic now. The most relevant scenario is a cooling inflation and growth that would allow central banks to halt the harshest monetary tightening in a generation. That means that the run-up in bond prices has legs, particularly when it comes to the investment-grade markets, which offer a decent amount of protection.

• Close to 3.5%, global high grade bond yields now are where high yield rated debt was trading at the start of last year (see the chart). Even if credit spreads do widen in 2023, an almost-tripling in global investment-grade corporate bond yields in the past 12 months gives investor returns a far bigger cushion to absorb such a move. 

• Furthermore, the current gap (1.3%) between the average yield on investment grade bonds (corporate & sovereign) and the average dividend yield for stocks in the MSCI World All Countries index, which is the widest since 2008, should also be welcomed by investors. In the US, where the rate hike is the strongest, the gap (2%) is even wider! The “TINA” (“There Is No Alternative”) mindset that has been dominating asset allocation over the past few years, favoring equities over bonds, is clearly gone now as bond yields look more attractive and as risks of recession are weighting on dividend expectations.
• Because they have longer duration, long-term bonds might perform better as the Fed keeps slowing down its pace of hiking and potentially even cuts rates later this year. US Bonds maturing in 10 years or more surged 7.5% in 2023, their best start of the year in decades, outperforming shorter-term securities (2.2% for bonds maturing in 1-7 year). 
• All these explain why investors are stocking up on blue-chip debt: demand for Europe’s debt has reached the equivalent of half a trillion dollars already this year, more than three times the volume of new debt issued!