IG Credit Outlook: Potential for a Technical Tailwind

1. What’s your overall view of the investment grade (IG) credit market?

We believe IG corporate fundamentals are largely stable based on our bottom-up research. US large-cap company earnings recently turned positive after three straight quarters of negative growth. We think margins and free cash flow can remain relatively stable over the next several quarters, and corporate balance sheets look healthy. We are keeping an eye on recent deterioration in interest coverage, which has declined with the dramatic increase in interest expense over the past year. According to JP Morgan, interest expense has reached Global Financial Crisis-era levels, and we expect this metric to deteriorate a bit more before rates begin to decline. Margins in the IG corporate market have also deteriorated modestly, with declines concentrated in specific sectors such as metals and mining, chemicals, technology, and media.

While spreads are currently tight, yields in the IG credit market remain elevated relative to history. Our breakeven analysis, which measures how much yields would have to rise to generate a flat return over a one-year holding period, indicates that current breakeven levels remain wide, offering potential downside protection. We believe this can help support total return potential even if spreads widen.

2. Is there anything unusual happening in the market that stands out to you?

One interesting theme we saw in 2023 was lower 30-year supply. The total notional value of 2023 long-end issuance was 13%, versus an annual average of 21% from 2019-2022.[i] According to Barclays, it was the lowest long-end issuance since 2011.[ii] Higher borrowing costs, volatility, and less M&A activity led to the lack of issuance out the curve. In addition to less supply, there was persistent demand for 30-year corporates from yield-based buyers, specifically pension funds and insurance companies. These dynamics drastically flattened 10-year, 30-year corporate curves during 2023.

We believe some of the supply pressures are likely to fade this year. With yields now lower than they were for much of 2023, we anticipate a pickup in M&A activity and more issuance as issuers come off the sidelines. We also anticipate continued strong demand for new issuance, which should help create a positive technical backdrop for the investment grade corporate market. We’re still seeing a lot of yield-based buyers in our market and we expect them to stick around for the first few months of 2024, especially if yields hang out near current levels.

3. What are the primary risks to your outlook?

In our view, primary market risks include above-trend economic growth and persistent "sticky" inflation. The market has seemingly bought into the “soft landing” narrative for now, which we believe is justified by recent positive inflation readings, signs of slower economic growth and a more dovish Fed reaction function. If growth and inflation sufficiently moderate over the next six months, we think the Fed may consider easing policy. However, if we see stronger growth or stickier inflation, the Fed may remain tighter for longer, increasing the risk of a downturn in the second half of the year.

We also have lingering concerns about regional US banks. While our outlook for US banks has stabilized in recent months, we believe regional US banks with a high percentage of loans made to office, multifamily and construction projects remain vulnerable if a downturn occurs. That said, conditions for banks and their commercial real estate borrowers have improved substantially since bond yields peaked in October. We remain focused on the strength of operating fundamentals and economic growth prospects for the banking sector.