2023-11-29 18:27:46
An uncertain economic outlook and high interest rates are generally not considered a positive environment for investment grade corporate debt (rated BBB/Baa and above). However, there are a number of factors that favor the asset class. These include relatively positive credit quality, high yield and a stabilizing environment in the banking sector.
In our opinion, and although investment grade credit could suffer strong sales pressure in an environment of risk aversion, the truth is that the duration profile of the sector, the credit fundamentals, which are more favorable than in periods previous economic stress, and sustained investor demand, should favor the asset class, limiting downside risk in most scenarios.
Overall, we think investment grade debt offers investment portfolios a good compromise. If the US Federal Reserve achieves a “soft landing” and avoids recession, investment grade credit should do well. If this landing ends up being abrupt, the market decline should be moderate in relation to what would be expected in the equity market.
Attractive duration profile ahead of the end of the Federal Reserve’s hike cycle
Periods of recession and the end of the Federal Reserve’s interest rate hiking cycle have historically been associated with falling rates and widening spreads. The Bloomberg US Corporate Investment Grade index has a duration of 7.1 years, compared to 5.5 years for the Bloomberg US Aggregate index, something that could be favorable in a scenario of slowing growth, and lead to a rise in rates long term as the Federal Reserve begins to ease its monetary policy.
Over the past three economic cycles, short- and long-term bond yields have fallen ahead of spreads rising. Thus, the duration of corporate debt has helped offset the impact of said increase in spreads.
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Before a potential recession, the yield on 10-year US Treasury securities could fall by 100 basis points to around 3.5%, and credit spreads could increase by the same amount, so investors’ capital would be relatively small. The income investors can currently earn from investment grade debt would continue to support total returns, but could decline as spreads compress. However, these periods of market volatility often provide an excellent opportunity for active stock selection to contribute to index performance.
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Liquidity and a more defensive posture: keys in an environment of economic uncertainty
Given the uncertainty of the economic outlook, we continue to emphasize liquidity, investing in defensive sectors that have tended to perform well in difficult economic environments and focusing on recently issued liquid issues for investment positions.
credit of our clients’ portfolios.
It is important to avoid investments that generate bad results and choose those that offer high profitability. Cyclical sectors, such as the chemical industry, may be threatened by the economic context of China and the United States, which have been the countries that have dominated cyclical demand in recent years. We are also reducing exposure to traditional automakers, which have been among the worst performers in the last two recessions.
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High level of absolute return attracts capital flows
When investment grade corporate debt yields reach or exceed 5%, increased capital flows into the asset class have tended to create favorable supply and demand dynamics that have put downward pressure on spreads.
Many investors who maintained an underweight exposure to credit are now rebalancing their portfolios, thereby contributing to demand. Some investors have also abandoned equities to enter the fixed income market, particularly among pension funds that execute liability-driven investment strategies. We believe that this favorable technical context could be maintained, as long as performance remains at high levels.
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The financial sector presents opportunities despite the Federal Reserve’s policy
The financial sector represents approximately one-third of the Bloomberg Investment Grade Corporate Index and a significant portion of the investment grade debt universe, and serves as a benchmark for the asset class. Given its continued financing needs, the sector is more sensitive to interest rates. Tightening monetary policy by the Federal Reserve often raises funding costs and puts pressure on deposits, which can affect bank profitability. Banks could also see greater losses in their securities portfolios as Treasury yields rise.
Bank bond valuations are starting to look attractive. However, in the short term, spreads could increase if the economy weakens, as banks do not typically perform well during recessions. However, despite the widespread downgrade of regional banks last August and certain difficulties facing the sector, our analysts remain optimistic regarding the credit fundamentals of certain issuers. with diversified deposit bases, solid business models and strong risk controls. Large global financial institutions are well capitalized, which is partly due to regulations passed after the global financial crisis and provides them with some support. For its part, the bankruptcy of Silicon Valley Bank and Signature Bank continues to affect large US regional banks. These two areas of the banking sector could offer attractive long-term investment opportunities.
If the Federal Reserve keeps interest rates high, smaller banks could face continued pressure on their earnings numbers and experience further rating downgrades. However, in the long term, these risks could be offset by stricter capital and liquidity regulations, which would strengthen fundamentals.
Apparent strength of credit quality
Overall, the credit quality of the asset class remains strong. Interest coverage is high and the level of leverage is low in historical terms. Refinancing risk is also low, as a large number of companies have borrowed at lower rates for several years.
The percentage of BBB-rated companies (one notch above high-yield debt) included in the index has increased from around 25% to almost 50% over the past thirty years, which could be a cause for concern. Some cyclical companies could be at risk of falling into the high-performing category in a downturn. However, strangely enough, BBB-rated companies may present a lower downgrade risk than in the past.
In recent years, encouraged by declining borrowing costs, many A-rated companies have been willing to accept a downgrade to fund their M&A activity and expand their businesses. But now, with a BBB rating, these companies are trying to do everything they can to maintain their investment grade status, given the serious consequences of downgrading to high yield. For example, many companies in sectors such as pharmaceuticals, food and beverages and energy have focused on reducing the level of debt they had accumulated to finance acquisition operations. In many cases, these companies would like to maintain the flexibility to make acquisitions in the future, which will encourage them to clean up their balance sheets so they can get back into debt at attractive interest rates.
Therefore, while some more cyclical companies may fall into the high-yield category, there are many that are continually improving their credit situation and can continue to reduce their debt level in an environment of slowing economic growth.
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