Corporates – a key component of a fixed-income portfolio

Following the price correction, investment-grade corporate bonds now come with attractive coupons. However, the macroeconomic environment presents risks. This is where Union Investment’s Global Credit Platform comes into play, as it offers bottom-up analysis and a worldwide perspective.

High inflation and the ensuing rise in key interest rates have put downward pressure on prices in the bond markets. Consequently, yields have shot up. Yields on ten-year German government bonds reached 2.3 per cent in mid-October, which is substantially more than the interest rates available on fixed-term deposits. The premium offered by corporate paper is even greater, although the risks in this case are different. For example, some investment-grade bonds are yielding around 4 per cent again. So is it now time for investors to reposition themselves?

The crucial factors are what will happen on the inflation front and what action will be taken by central banks and governments in the months ahead. The surge in inflation is forcing central banks to rapidly implement substantial interest-rate hikes. They are thus deliberately moving to put the brake on economic growth, and Union Investment’s economists believe that the US will now be unable to avoid a mild recession. An even bigger slump in economic output is likely to be seen in Germany and the rest of Europe, where persistently high energy costs are exacerbating the situation.

Looking back, it is clear that the losses in the bond market were primarily due to elevated interest-rate expectations and not so much to fears about rising issuer default rates. Nevertheless, much higher coupons are now being paid in response to the sharp drop in prices. For the first time in a long while, the bond market is therefore offering investors a degree of protection against any further price falls. This has rarely been the case in the past ten years as most paper offered only low coupons – or none at all – against a backdrop of modest levels of risk.

Many risks priced in

As a result of the war in Ukraine, there is still a great deal of uncertainty about how quickly inflation will fall. Another consideration is the introduction of fiscal measures that may also impact on the bond markets, as illustrated by events in the United Kingdom. Depending on households’ existing situation, the effects can be substantial when a government misses the mark (as was the case in London). That is why turmoil erupted in the UK bond market. However, Union Investment’s experts believe that the bond markets are already largely pricing in the challenging mix of inflation and rising interest rates. This will open up new investment opportunities in the medium term, although there are still risks to contend with and the bond markets are likely to remain susceptible to volatility for the time being. Fixed-income investors should therefore take a selective approach that focuses on high credit quality and avoids the sectors that have been hit particularly hard by the energy crisis. These are generally the chemicals and industrial sectors, plus consumer-linked companies.

The fundamental picture, which is more constructive overall, is based on the assumption that inflationary pressure will recede markedly in 2023, not least because the months that saw sharp price rises – such as for energy and commodities – are gradually dropping out of the calculation of year-on-year inflation. Delayed effects of rising interest rates should also help to slow down inflation, as should the easing of the supply chain problems that is now evident. The main source of uncertainty is the level that interest rates will have reached when the cycle of interest-rate hikes comes to an end, i.e. the terminal rate. The US Federal Reserve (Fed) has made combating inflation its number one priority. Union Investment expects the US federal funds rate to have risen to a range of 4.25 percent to 4.50 percent by the end of this year. The forecast for the European Central Bank (ECB) is that the rates for the deposit facility and marginal lending facility will be at 2.25 per cent and 2.75 per cent respectively by the end of 2022.

Unusually heavy losses on euro corporate bonds

Most losses attributable to the general rise in yields – good fundamental situation so far

Unusually heavy losses on euro corporate bonds
Sources: Refinitiv, Bloomberg, as at 7 October 2022.

In the eurozone, the experts at Union Investment only partially share the market's expectation of further interest rate hikes and expect the ECB to raise rates by a further 50 bp in the first quarter of 2023. If the interest-rate cycle is brought to a (temporary) halt due to a recession, high-quality fixed-income investments will provide opportunities for price gains as their function as a safe haven should push up demand for them. However, caution is required when it comes to bonds from eurozone periphery countries due to their difficult budgetary situation, for example Italy. In the US government bond market, the experts believe a further – albeit less pronounced – increase in yields is likely. At present, the market is pricing in interest-rate cuts over the course of 2023, but this does not tally with Union Investment’s expectations. Inflation has probably now peaked in the US, but future monetary policy will be determined by the situation in the labour market and the core inflation rate (i.e. excluding food and energy prices). The downturn is likely to be less steep here.

Unremarkable rating trends in the corporate segment

Going forward, the bond market will generally offer opportunities for new investments. The looming recession should make it easier for central banks to follow a more moderate monetary policy line next year. In the fixed-income experts’ view, this means investment-grade corporate bonds with short or medium terms to maturity will be particularly interesting as they offer high coupons and thus a partial buffer against any further interest-rate rises and price falls. But given the economic risks, it is important that investments are broadly diversified – using a fund, for example – so as to reduce default risk. In terms of the fundamentals, however, the rating trends in the corporate bond segment have been unremarkable so far. Large-scale issuers, in particular, are at low risk of default because they can absorb the effects of higher costs more easily. And according to Union Investment’s fixed-income experts, higher nominal revenue growth driven by inflation should cause companies’ debt levels to hold steady or even fall slightly.

Despite the recession, default rates are expected to remain modest. Extreme risks resulting from a potential gas shortage can be avoided by means of active security selection. Union Investment’s experts have access to a global investment universe that is broadly covered by the company’s proprietary Global Credit Platform. This can be used to ascertain which bonds appear especially good value compared with the rest of the sector, including after currency hedging.

Corporate bonds now offering historically high yields

Corporate bond yields back at dividend level for first time since 2012

Corporate bonds now offering historically high yields
Source: Macrobond, as at 10 October 2022

Looking ahead, higher inflation should support corporate bonds because the debt levels of companies with a functioning business model should tend to sink. The financial sector may also benefit from rising interest rates as these result in higher interest income. Moreover, capital adequacy is good for the most part, which provides a sufficient buffer to cope well with increased loan default rates. In addition, many recession-related risks have already been priced into risk premiums. A further significant widening of spreads will therefore be unlikely if the economic baseline scenario materialises. Nevertheless, investors need to remain cautious in their positioning. If the recession is more severe than expected, high-yield paper will probably come under particular pressure as it is more susceptible to the widening of spreads. As it is not certain when the central banks will stop tightening the monetary policy reins, investors should generally avoid an overly long duration and opt for investment-grade paper. In this context, the new issues market for actively managed fixed-income funds regularly offers new investment opportunities. However, caution should be exercised as the high levels of liquidity in the subordinated and high-yield segments are now falling.

The advantage of collateralised loan obligations (CLOs) is that they are immune to changes in interest rates. After all, structured credits are barely affected by interest-rate volatility thanks to their floating interest rates. However, they do react to spread changes. During difficult phases in the bond markets, their spreads widen markedly and they therefore offer higher yields than corporate bonds, even if they have higher credit ratings. There is empirical evidence to prove this. A Union Investment study showed some time ago that higher yields are the reward for high spread volatility during times of crisis. In terms of the fundamentals, however, the underlying rating trends remain intact – even in view of the imminent recession – and ought to be sustainable.

 

As at 10 October 2022.

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