It has been a dismal start to the year for corporate bond funds. The average UK sterling corporate bond fund has seen double-digit falls since the start of the year as a toxic combination of rising inflation, rising interest rates and waning risk appetite have dented returns. Investment grade bonds have fared even worse than high yields bonds. It has been thin pickings for the average credit manager.
However, some fund managers are starting to predict a turn in the environment. Ariel Bezalel, manager of the Jupiter Strategic Bond fund, says: “Fixed income yields have become incredibly attractive – this is perhaps the best time to buy fixed income since the global financial crisis.”
Bob Michele, JPMorgan Asset Management’s chief investment officer, says corporate bond markets have already priced in a recession and investors are returning.
Seth Meyer, portfolio manager at Janus Henderson, says that the repricing in corporate bond markets has been a necessary response to a changed environment.
“Rates are higher, so coupons are higher. Spreads should be wider because there is a need to reprice risk given the slowdown in GDP. There is also the uncertainty created by the war in Ukraine. These things weren’t priced in on 1 January and are now priced in. We are also facing an aggressive Federal Reserve and central banks around the world, who are trying to bend the curve on inflation.”
This is why yields now look so attractive, particularly given that default rates remain low.
Default rates will go higher
On the other hand, corporate bond bears might argue that the pain of the economic recession has yet to be felt.
Meyer agrees that this is a consideration: “In the lower quality asset space, people feel more comfortable because defaults rates are low. However, they are a backward-looking indicator – default rates are likely to go higher simply because companies’ ability to absorb debt will be impaired.”
Nevertheless, he says, there are mitigating factors. He points out that 45% of the defaults in the US have been in the energy sector, but at the moment, energy companies aren’t showing signs of stress because of the price of oil.
“We also see these companies repairing their balance sheets. While default rates will go higher, the most stressed sectors are not stressed.”
In the meantime, the risks for corporate bonds are significantly reduced by the yields on offer. Spreads have widened considerably over government bonds, reducing the likelihood of losing money over the short-term.
Meyer adds: “Investors are getting paid a nice coupon to sit back, wait and watch as risk assets stabilise.”
Opportunities in US investment grade
It is still a market that requires an active approach. Capital Group, for example, has been hunting in the US investment grade sector.
Flavio Carpenzano (pictured), Capital’s fixed income investment director, says: “With the recent sell-off related to higher inflation and interest rates, as well as concerns about a slowing economy, we have been incrementally and modestly increasing our exposure to US investment grade. Specifically, we have found value in certain financial services, healthcare and media issuers.”
Meyer says: “As active managers, we’re looking to take advantage of dislocated values. We wouldn’t be calling the bottom of the market, but with spreads at these levels, our inclination is to lean in.”
They’ve been focused on BB-rated bonds, believing investors are over-compensated versus BBB-rated bonds while balance sheets remain strong in this part of the market.
With no peak in inflation yet materialising, Carpenzano admits it may take a while for the market to shift.
“Although fixed income markets, and in particular credit markets, are poised to deliver attractive total returns over the next five years, there is still a lot of uncertainty ahead,” he cautions.
“The risk of recession has been increasing over the last few months alongside more hawkish central banks hiking interest rates and tighter financial conditions combined with higher commodities prices impacting disposable household income.”
But the investment grade credit market certainly has more appeal today than at any other point in recent history: income generation, for example, “at the same US high yield market offered at the end of 2021”, says Carpenzano.
It also offers potential capital preservation at a time when other assets are rocky.
He adds: “The market has started to focus on the risk of slower growth and the higher risk of recession in 2023; however, even with a deteriorating growth picture, fundamentals in investment grade credit are still strong and corporates can navigate a low growth environment. Default risk in this part of the market has been historically low and is expected to stay very low.”
There is also the question of diversification from equities. At a time of quantitative easing and low interest rates, the negative correlation between equities and bonds broke down, but should now start to reassert its as interest rates rise.
Carpenzano points out that over the long term, the correlation between investment grade corporate and equity market has been close to zero.
Bezalel says: “Looking at the current environment, where tighter monetary policy and declining growth are already putting pressure on credit spreads, it’s not a great time to hold lots of market beta in credit.
“An active approach of only investing in issuers we know, and where we see risk mispriced or a catalyst for deleveraging, is key for us at this point and it ensures we keep dry powder to reinvest in credit markets when spreads become more attractive.”
Carpenzano says that although the path to getting there might be bumpy, the broad credit universe provides scope for investors to add value through active management across all the major credit sectors.