As credit spreads have compressed to post-global financial crisis tights, and with bond yields hovering near all-time lows, I believe the total and excess return prospects for investment-grade fixed income look rather grim. Tight valuations, coupled with some looming risks on the horizon (the COVID Delta variant, inflationary pressures, fading fiscal stimulus, and China’s slowdown), may present an opportunity to “take some chips off the table,” so to speak. I recommend reducing both credit and interest-rate risk in many investor portfolios.
The technical backdrop remains strong
Investment-grade credit has been well-supported by strong demand from non-US investors and the domestic pension community. For overseas investors, US credit is still their best option on the yield “menu” (made even more attractive on a currency-hedged basis), given lower prevailing yields across most other developed markets. Many defined benefit pension plans have been “locking in” improved funded status by derisking out of equities and into long-maturity corporate bonds.
On the supply side, new investment-grade issuance is only slightly lagging last year’s record pace, yet still fails to satisfy the insatiable appetite for yield. In short:
- We continue to live in a world where global demand for yield (and thus credit) outpaces the supply of credit investments.
- There simply isn’t a viable alternative available to most users of US-dollar-denominated investment-grade credit.
- We expect this dynamic to persist for the balance of 2021, although it could be challenged by eventual “crowding in” to US Treasuries and mortgage-backed securities that will need to find homes as the US Federal Reserve’s (Fed’s) asset purchases are tapered.
Fundamental improvement may have peaked
Boosted by conservative financial policies, extraordinary fiscal stimulus, and pent-up consumer demand, credit fundamentals have improved markedly over the past year:
- Free-cash-flow generation generally held up well through the COVID shock, as many companies pulled levers to maintain adequate liquidity, while leverage declined for a third consecutive quarter — now back to pre-pandemic levels.
- Shareholder-friendly business moves remain muted for now, but merger-and-acquisition (M&A) activity could pick up if issuers look to take advantage of low borrowing costs by issuing more debt to diversify or increase the scale of their business.
- At the corporate index level, cash flows should be more stable going forward, given the less cyclical mix of sectors (more technology, health care, and pharmaceutical companies), as well as banking regulations that have reduced banks’ exposure to systemic risk.
Interest-rate risk is on the rise
I expect the growth and inflationary pressures over the next 12 months to be stronger and more enduring than the market expects, which should push US Treasury yields higher. While supply bottlenecks will eventually resolve, they remain concerning for now. There are signs that price increases have begun to broaden out to more sustainable components of inflation, including rents and domestically generated core services. Commodity price pressures may persist for much longer than what’s currently implied by their futures-market curves (oil, copper, iron ore, steel).
Despite my forecast of persistently higher inflation, I do not expect the Fed to prematurely tighten monetary policy (as some investors fear), but rather to proceed at a glacially slow pace. The Fed will be monitoring financial conditions closely, and if the rhetoric around tapering of its asset purchases causes conditions to deteriorate, it may delay the start of any policy tightening. The recent approval of additional US fiscal stimulus could warrant an earlier start to tapering, but given that full employment has yet to be achieved, I believe the Fed can afford to take a more patient approach.
What are some investment considerations?
In an environment of potentially higher inflation, a patient Fed, and tight credit spreads, I favor reducing both credit and duration risk. Likely “winners” under this scenario would include many global commodities, but the opportunity set there is rather limited outside of energy companies and emerging markets.
In terms of credit, I prefer the front-end to intermediate parts of the yield curve, as the risk/reward trade-off for investing further out on the curve appears skewed to the downside as of this writing. While I acknowledge the current technical support for the long end, it would only take a small rise in rates to erode its carry advantage, given the prevailing low absolute levels of yields and longer durations. I do not think there is enough of a spread cushion to take this risk right now.
I believe it’s prudent for most investors to maintain a larger-than-typical reserve of high-quality, liquid assets (cash and US Treasuries) so as to be able to exploit the market dislocations that may occur in the months ahead. Bouts of market volatility will likely generate greater idiosyncratic dispersions, potentially creating opportunities to capitalize on inefficiencies in the pricing of risk.