Corporate bonds : rotation to quality will expose junk bonds’ fragilities
By Althea Spinozzi, Senior Fixed Income Strategist at Saxo
As the macroeconomic picture becomes more hostile, with interest rates remaining at the highest level in over twenty years and the economy decelerating markedly, investors will soon need to shift their focus from inflation to quality. Junk corporate bonds, which have provided a much-needed buffer against inflation in the past couple of years, have deteriorated noticeably compared to pre-COVID averages. In some cases, leverage has almost doubled while interest coverage has dropped sharply. With the risk-free rate at 5%, it doesn’t make sense to take additional credit or duration risk. Therefore, rotation from junk to quality will likely accelerate in the next few months, widening corporate spread significantly. Yet, investors can secure a pickup over the risk-free rate without taking excessive risk in sectors such as basic industry, energy, and capital goods, whose fundamentals have sensibly improved since pre-COVID. Although we remain defensive in terms of duration, there are selective opportunities for income seekers in the long part of the yield curve.
During the past couple of years, investors’ only hope to build a buffer against inflation was by building a junk bond portfolio. The reason is simple: lower-rated bonds have been offering a yield and coupon high enough to become an effective hedge against elevated inflation while the US economy was still buoyant. According to Bloomberg indexes, junk bonds returned 7% year to date. In contrast, investment-grade corporates returned 1% within the same time. With inflation averaging more than 4% throughout the year, high-grade assets provided a negative real total return.
As price pressures and the economy slow, investors' attention gradually shifts from inflation to quality. While junk bond yields went from 5.1% at the beginning of 2020 to 8.9% today, that 380bps move higher can mostly be attributed to rising rates. The US junk credit spread has only widened by 60bps in the same period. With interest rates more than double where they were in 2019 and the economy starting to falter, it is impossible not to expect an increase in defaults that will inevitably widen credit bond spreads.
Therefore, we expect rotation from risky assets to quality assets to begin ahead of Christmas but to be prominent during the first half of 2024. Investors will be compelled to rotate from junk to the risk-free rate now that US Treasury yields pay 5% more or less across the whole yield curve rather than sitting on deteriorating junk at 9%. That will apply pressure on the high-yield-investment-grade spread (HY-IG), now trading around 270bps, in line with pre-covid valuation. Within the current macroeconomic backdrop, the HY-IG spread will likely widen to 400bps and spike above that level in case of distress.
Investment-grade corporate bonds
When looking at the corporate bond space, leverage, and interest coverage are key metrics.
Financial leverage is important and is commonly used to increase investors’ return on capital invested. However, it can also be misused, and too much leverage might become unsustainable if a firm incorrectly forecasts future sales.
Similarly, a high interest-coverage ratio indicates a company's ability to pay the interest on its existing obligations to creditors.
As a general rule, when bond investors are looking for good assets and stable returns, they will look to minimize leverage and maximize interest coverage.
The communication, electric, transportation, and consumer-noncyclical sectors have seen notable deterioration in fundamentals, while basic industry, capital goods, and energy have improved.
The macroeconomic backdrop agrees with this picture: as the economy slows, anything related to consumer spending is at risk. However, geopolitical uncertainties and nationalization provide fertile ground for commodities and raw material-related sectors.
There are some exceptions. Although the technology sector doesn't stand out, it is still characterized by one of the lowest leverage (2.14x) and the highest interest coverage (14.44x), making it a great and stable place for income-seekers.
On average, US investment-grade corporate bonds are paying a 6% yield across the yield curve. While we expect long-term US Treasury yields to rise again as the Federal Reserve stays on hold, it is worth picking duration risk selectivity and gradually increasing one portfolio's duration.
High-yield corporate bonds
When looking at lower-rated corporate bonds, we see that fundamentals have deteriorated markedly in the high-yield technology sector, with leverage nearly doubling compared to pre-COVID averages and interest coverage dropping sharply. The consumer non-cyclical and communication sectors have also worsened noticeably. Corporate bonds in these sectors have above-average leverage (4.9x) and below-average interest coverage (3.22x).
The good news is that basic industry, capital goods, and energy saw fundamentals improving markedly within the same period.
High-yield corporate bonds pay, on average, 9% in yield across the yield curve. Thus, taking a higher duration risk might be worthless. What investors have to bear in mind, however, is that the macroeconomic backdrop is now unfavorable for junk bonds and that a wall of maturities is coming up in the second half of next year, increasing the chances of defaults and a widening of credit spreads. It is, therefore, critical to cherry-pick when selecting credit risk in this space.
What opportunities are available in corporate bonds?
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