- US investment grade corporate bonds are potentially good value
- Underlying fundamentals could buy the Fed time to achieve its inflation mission
Corporate bonds yielding in the region of 5 per cent are starting to look a bargain, so long as investors are convinced of two things: 1) galloping inflation can be reined in; and 2) yields are overcompensating the true likelihood of companies defaulting in a recession.
Many private investors will leave bond market complexities for the professionals, but the read-through to shares is significant. “The bond market is like the equity market’s big brother, in both size and importance”, said Paul Hawkins, a former City corporate bond trader, now head of an eponymous asset management firm.
Bonds pay a fixed coupon and give investors a senior claim to assets in the event a company is wound up. Therefore, while they are very concerned with external factors such as inflation and interest rates, credit investors’ main question for individual companies is whether they are sound as going concerns.
In other words, so long as the business generates a baseline amount of cash to keep running and meet its obligations, excess profits don’t matter to corporate bondholders. With headwinds to company earnings, credit arguably offers better value than shares relative to risk, which is another factor potentially weighing on share prices.
More importantly, the spread between yields on credit and safer government bonds suggests weakening confidence in the economy. But if the negativity is overdone it could spell opportunity.
Powell back in the saddle?
When the US Federal Reserve Open Market Committee (FOMC) announced a 75 basis point rise in interest rates in June, the new 1.5 to 1.75 per cent target range represented the biggest hike in relative terms since Paul Volcker was Fed chair in the 1980s. Back then, the focus was on quelling rampant inflation and, with another 75bp increase widely expected in July, incumbent Jay Powell is showing resolve to cool demand in the US economy and bring rising prices under control.
Heavier measures have downsides, though. The harder monetary brakes are applied, the more rapid a slowdown in consumption, so chances of the Fed engineering a soft landing for the economy are diminished.
But if the net result of the Fed’s actions is just a couple of quarters of below-trend growth and not recession, then today’s pricing of credit risk is overly generous. The yield on the Bloomberg US Corporate index of investment-grade bonds is hovering around 4.7 to 4.8 per cent, compared with 3.87 per cent for the equivalent US government bond index.
That spread represents a decent premium for investing in the structured term debt of companies that are very unlikely to default on payments. Furthermore, if the Fed is finally ahead of the curve on inflation, then the balance of risks around interest rate policy are likely to be more neutral in the second half of 2022.
Analysts from Franklin Templeton offer cautious optimism that this could be the case. Another multi-decade high inflation figure of 8.6 per cent precipitated the Fed’s latest hawkish turn, but the analysts noted ‘stickier’ components of inflation that worry policymakers, such as housing costs, are backward-looking, with the effects of what was happening three to six months ago showing up in the US consumer prices index now.
Figures that move more in real-time demonstrate signs of slack, such as wage growth and US non-farm payrolls, which show the number of job openings created in the economy. Although both these indicators are running less hot than a few months ago, by historic standards they are still high, lending hope that the US consumer can weather the storm of rising rates.
In the view of Gene Podkaminer, head of research at Franklin Templeton Investment Solutions, the US economy’s underlying strength buys Powell and the FOMC time. Recession can’t be ruled out, but from this point it will take long enough to materialise that the Fed will have ample opportunity to see inflation data easing. Strong rate hikes over the summer will also give the wriggle room to potentially make a dovish policy pivot should growth slow too much.
Right now, the US Treasury market is pricing for higher rates, and the credit market is pricing for recession. If too much pessimism has crept in on both counts, the outlook for investment-grade corporate bonds is potentially bullish.
Should UK investors feel comfortable enough to make that call, they can get exposure to both risks through some of the mid-duration US investment-grade exchange traded funds (ETFs) that are available. Duration is a tricky concept, but it is most simply interpreted as a measure of a bond’s price sensitivity to interest rates. The iShares $ Corp Bond UCITS ETF (LQDE) has an effective duration of 8.72 years, so offers a contrarian play on interest rates for the second half of the year, as well as quality credit.
For those who think a Fed dovish pivot is too much of a leap of faith, the shorter duration (2.29 year) iShares $ Short Duration Corp Bond UCITS ETF (SDIG) is an option.
