The sell-off in most fixed income assets over the course of 2022 has been brutal. Pernicious and stickier-than-expected inflation, a hawkish US Federal Reserve (Fed) laser-focused on the inflation portion of its dual mandate, and the ongoing Russia/Ukraine conflict have derailed the decades-long fixed income bull market. However, the two biggest drivers of this year’s downturn have begun to abate:
- Inflation is gradually cooling. Of particular note, US inflation may have peaked, as demonstrated by the November CPI and PPI readings.
- The Fed is likely to start slowing the pace of its interest-rate hikes, due both to incoming data and recent communications from Fed officials.
While macro uncertainties remain, and market volatility is likely to stay elevated, we believe large swaths of fixed income look more attractive than they have in some time.
The opportunity in high-quality corporate credit
One area that we believe stands out these days is the investment-grade (IG) corporate credit market. As of this writing, current yields on IG credit are in the mid-single digits — a decade-long high. Most of these high-quality companies have very low default risk, and many have been trading at significantly discounted US dollar (USD) prices. For example, as of November 30, the Bloomberg US Investment Grade Credit Index traded at an average yield of 5.3% and an average USD price of $89.1. A low USD price can be an important credit metric: In the unlikely case of distress or default, the bondholder has legal recourse to seek the bond’s full par amount (face value), even if it was purchased at a below-par level.
Moreover, while a slowing global economy could lead to wider credit spreads going forward, we believe USD rates have now reached levels that can potentially serve as an adequate cushion against a broader sell-off in risk assets. The defense supplied by this cushion is twofold: 1) higher bond coupons (yields) that can help offset any short-term market price declines; and 2) the historically diversifying nature of having portfolio exposure to interest-rate risk and credit risk.
Portfolio implementation considerations
There are some relatively simple, straightforward ways to implement a positive view on IG credit. For instance:
- Fixed-maturity bond portfolios: These are one flavor of “buy-and-maintain” fixed income strategies, where the underlying bonds and the vehicle life are matched together. For example, consider a five-year end-date portfolio consisting entirely of bonds that mature in four to five years. Over the five-year lifetime, this portfolio would have no-to-low expected turnover, instead relying on deep credit research for security selection and credit monitoring. In essence, you’d be able to lock in today’s interest rates for the next five years, providing a stable and higher level of coupon. (As of October 31, five-year fixed-maturity portfolios yielded between 5.8% and 6.7%).
- Total-return credit strategies: A more nimble and dynamic investment approach could be through a total-return credit strategy, which typically purchases IG credit assets when both yield and USD price skew become compelling (in the portfolio manager’s judgment). When credit opportunities are hard to find and valuations not that compelling, the strategy may resort to investing in US Treasuries. Unlike benchmark-sensitive strategies, this approach would be predominantly invested in either IG credit or the relative safety and liquidity of Treasuries, depending on the opportunity set.