CONTRIBUTORS
Kurt Halvorson, CFA
One of the many things puzzling investors about today’s financial markets is the disparity between the high level of uncertainty about the future path of the global economy and the resilience of risk asset prices. As of yesterday, the S&P 500 is up about 8% for the year to date while the Nasdaq has advanced an impressive 17%,1 all while the bond market and other traditional signals are indicating that a recession is almost imminent. So what is an investor to do? If the economy is on the cusp of a downturn, then current P/E multiples in the equity markets are approaching the nosebleed section which means investors have very little cushion if growth hits a wall. At the same time, the labor market has demonstrated such strength that perhaps the soft landing will be the right call after all. This has left investors in an uncomfortable position when it comes to their portfolios.
We have a strong view that investment-grade (IG) credit currently offers investors attractive return potential while also providing significant cushion in the event that the economy turns down. While credit spreads are currently trading toward the tighter end of the one-year range, the all-in yield within the IG credit space remains closer to the highs of the past several years and offers what we believe is a compelling risk/reward profile for investors who are seeking return while not taking a lot of risk given the uncertain environment. We believe a portfolio of high-quality names with robust balance sheets currently offers compelling yields. We view this as the most attractive investment out there, considering the underlying safety within the corporate bond sector.
The fundamentals for IG credit remain very strong, in our view, perhaps stronger than at any previous time of uncertainty like we’re seeing today. Why is this? There are a few contributing factors, but the most important in our opinion is that management teams have not forgotten the lessons learned from the global financial crisis (GFC) of 2008 or during the Covid shock of 2020. These two events helped shape the behavior of current management teams, and as a result they typically operate within much more conservative parameters. We believe CEOs by and large are well prepared for surprises and have made the necessary changes to shore up their balance sheets. In addition, economic weakness and possible “hurricanes” have been forecast by major CEOs for over a year now, which means that most companies have been preparing for such scenarios and building adequate buffers to weather any storms.
Within the IG space, we think investors are currently being well compensated to maintain or even add exposure to the US banking sector. Admittedly, the events of March initially caught us off guard. However, investors should keep in mind that the US banking sector is comprised of two separate systems, large cap banks and regional banks. As we have seen already this year, smaller banks with vulnerable capital structures will struggle in this environment and we may see more turmoil in the coming months. However, the large US money center banks are actually the beneficiaries of the smaller banks’ problems. What’s more, we do not view the idiosyncratic issues that led to regional bank failures as systemic. The large US banks are currently very profitable with well-entrenched, low-risk business models and robust balance sheet strength. In short, with US bank spreads near the widest levels versus industrial spreads since the GFC and near-record earnings for the large US money center banks in 2023, we believe this sector is poised for outperformance.
Along the maturity curve, we currently view the belly as the most attractive spot for investors, due mainly to the inversion of the Treasury curve. Portfolios can be constructed in a way that seeks to optimize yield while maintaining a shorter-maturity bias and focusing on the income portion of the bonds rather than the price appreciation. This can help to protect investors against unnecessary duration risk within the credit space.
One additional consideration for investors is liquidity. The IG corporate bond market now stands at over $8 trillion dollars and as such offers tremendous liquidity—an important factor when considering asset allocation. This is an underappreciated characteristic within markets. In our opinion, this is an opportunity for investors seeking attractive annualized returns while taking very little credit risk to also maintain ample liquidity should they want to reallocate at any time.
In summary, we see the current IG credit market as a very compelling opportunity from a risk/reward standpoint. An economic slowdown is now being forecast by most, including the Fed that has signaled a “mild recession in the back half of 2023.” This only further boosts the case for locking in attractive yields as high inflation looks to be in the rearview mirror and interest rates are likely to gravitate lower as the year progresses.
Endnote:
- Source: Bloomberg, as of May 9, 2023.
Definitions:
Investment grade refers to the quality of a company's credit. To be considered an investment grade issue, the company must be rated at 'BBB' or higher by Standard and Poor's or Moody's. Anything below this 'BBB' rating is considered non-investment grade.
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