5 reasons for optimism about high-quality credit

 

Concerns about when —or even if—central banks will start cutting interest rates this year have dampened bond market momentum since January, after mixed signals from policymakers cast doubt on the timing of rate cuts.

The uncertainty has thrown a spanner in the works of what was broadly expected to be a banner year for fixed income markets globally, amidst a backdrop of falling rates which would lead to strong returns for bond investors.

While most areas of fixed income have been on the decline since the start of the year, investment-grade (IG) corporate bonds have continued to perform well, with strong demand pushing down spreads to near-record-low levels, as the chart below shows. US IG credit spreads are currently trading below 1.0% – well under their long-term average of 1.5%¹. European IG credit spreads are running slightly wider, at around 1.2%, but are still tighter than their historical average of 1.4%².

 

Demand is pushing down credit spreads below their long-term averages

Corporate investment-grade spreads (%)

 

Notes: The chart shows the historical daily option-adjusted spreads of US and European IG corporate bonds, for the period 29 February 2004 to 29 February 2024. Proxies used: For US IG corporate bonds: Bloomberg US Corporate Bond OAS Index; For European IG corporate bonds: Bloomberg European Corporate Bond OAS Index.

Source: Vanguard and Bloomberg. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

 

Positive outlook for high-quality corporate credit

 

Despite concerns that valuations look stretched, we maintain a positive outlook for IG credit, for several reasons:

 

1. Attractive yields

IG credit spreads may be tighter-than-average, but yields continue to be attractive; and in some cases, can offer higher income than equities.

 

Credit can offer higher income than equities

 

 

Notes: The chart shows the historical monthly income yields of IG corporate bonds versus US and European equities and emerging market bonds, for the period 28 February 2012 to 29 February 2024. Proxies used: Global IG corporate bonds: Bloomberg Global Aggregate Credit Yield-To-Worst Index; Emerging markets bonds: MSCI Emerging Markets Bond Index; US equities: S&P 500 Index; European equities: Bloomberg STOXX Europe 600 Price Index. Yield calculations are in local currencies.
Source: Vanguard and Bloomberg.

 

2. Supportive technicals

January’s much-anticipated uptick in corporate new issuance was easily absorbed, due to a supportive backdrop and sustained strong demand for credit. Much of this year’s new issue supply was front-loaded and has already occurred. We expect modest supply levels going forward, providing a supportive technical backdrop for the remainder of 2024.

 

3. Cushion against rate volatility

This year, we’ve seen how interest rate uncertainties can cause re-pricings in fixed income markets. IG corporate bond spreads can help cushion the impact of further potential volatility that may be caused by changing interest rate expectations. 

If we see rates staying higher for longer because of strong growth, IG credit spreads could wind up tightening a bit more from current levels, providing further protection against the negative price impact of government bond movements.

 

4. Post-peak window of opportunity

Typically, the end of interest rate hiking cycles has been an opportune time to add exposure to high-quality corporate fixed income. In previous hiking cycles, after rates had peaked, IG corporate bonds generated strong returns over the 1- and 3-year periods that followed³.

Even if this year’s anticipated rate cuts are pushed out past current forecasts, any near-term increases in corporate bond yields are, in our view, likely to prove temporary and should eventually fall to lower levels than where they are today – resulting in strong returns for corporate bond investors.

 

5. Strong fundamentals

We expect investor demand to continue tilting towards higher-quality corporate issuers that can better weather uneven conditions going forward. Valuations may look stretched, but we think IG companies in the aggregate are well-positioned to navigate potential economic turbulence, with solid balance sheets and healthy earnings that could support any near-term cash flow strains.

 

Active credit managers can enhance returns in an uneven market

Tighter-than-average credit spreads highlight the importance of security selection in generating performance in the current credit market.

While the outlook for high-quality corporate bonds is positive, risks remain. When credit spreads are compressed, active strategies with a focus on bottom-up security selection and fundamental analysis can help investors mitigate exposure to downside inflationary and credit risks, while capitalising on idiosyncratic return opportunities when they occur.

Vanguard’s seasoned team of credit research analysts help our active fund managers identify and avoid vulnerable credits. Equally, when volatility hits, our active managers can take advantage of dislocation opportunities and add credit risk at more attractive levels.

 

Publication date: May 2024

For Advisor use only. Not for public distribution.

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¹ Source: Vanguard and Bloomberg. Based on the historical average spread of the Bloomberg US Corporate Bond OAS Index, for the period 29 February 2004 to 29 February 2024.

² Source: Vanguard and Bloomberg. Based on the average daily spreads of the Bloomberg European Corporate Bond OAS Index, for the period 29 February 2004 to 29 February 2024.

³ Source: Vanguard calculations. Based on average 1- and 3-year investment-grade bond returns during previous rate hiking cycles in the US, after rate hikes were completed.