Fixed income markets have had plenty to digest this year and we’re barely into the second quarter. Hotter jobs and inflation data early on helped push market expectations for the federal funds rate to cycle highs in early March, then the focus quickly shifted to banking sector turmoil as concerns about a potential contraction of credit availability spooked risk assets. In our view, the market’s skittishness underscores the murky outlook for interest rates and credit spreads. But we think bonds currently offer value, particularly investment grade (IG) intermediate corporate bonds, regardless of where rates and spreads go from here. Here’s why.
All-in yields remain elevated relative to history
It’s worth acknowledging that credit spreads and Treasury benchmark yields have rallied significantly from recent highs. But zooming out to a longer-term perspective reveals that yields on the Bloomberg Investment Grade Intermediate Corporate Index are still considerably higher than they’ve been since the global financial crisis. In our view, yields near 5% currently offer an attractive entry point signaling potentially favorable return prospects relative to recent history.
Shorter- and longer-term corporate yields have converged
The deeply inverted Treasury yield curve, coupled with a flattened US corporate credit spread curve, has resulted in all-in yields between shorter- and longer-term corporate bonds converging. Corporate yields are typically upward sloping, offering increased yield potential as you go further out in maturity to compensate for the added duration and credit risk. But that is not the case today. Currently, the difference in yield between long-duration and intermediate-duration bonds (as measured by the Bloomberg US Long Corporate Bond Index and the Bloomberg US Intermediate Corporate Bond Index, respectively) is around 30 basis points, a skinny margin compared to the 10-year average of 160 basis points.[i] In our view this implies that, all else equal, the forward return potential between the two buckets looks fairly similar despite the interest rate sensitivity (duration risk). Because longer-maturity corporate bonds generally come with additional duration risk, we think IG intermediate bonds can offer more attractive value per unit duration at current yields, which remain elevated relative to history.
Break-even rates may help preserve total returns
Higher yields in the IG intermediate corporate space may provide greater defense against further rises in rates or widening spreads. Break-even analysis shows how much yields can rise for a bond to break even, or in other words, generate a flat return over a one-year holding period. A higher yield relative to duration translates to a wider break-even rate. As shown below, intermediate corporate yields could increase another 120 basis points from current levels and still potentially produce a positive total return if held over a 12-month period. The level of defense has tripled since the beginning of 2022.
Potential to retain value amid rallying rates and widening spreads
After recent market volatility, the market appears to be pricing in higher odds of Federal Reserve rate cuts later this year, which in our view suggests expectations skew toward an approaching downturn. Remember, financial markets are generally forward-looking. While credit spreads are not currently at extreme levels, they have widened off of recent lows as investors demand greater risk premiums to compensate for the uncertain outlook. We think IG intermediate-maturity corporate bonds currently offer a fresh value proposition, with all-in yields and an ample breakeven “cushion” that we believe can help the segment retain its value amid rallying rates and widening spreads.
[i] Source: Bloomberg, as of 25 April 2023.
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