15 min read 16 Nov 22
The views expressed in this document should not be taken as a recommendation, advice or forecast.
One of the sharpest bond market sell-offs on record took place in 2022, as concerns over persistently high inflation and an aggressive tightening in monetary policy have pushed government bond yields to their highest levels in over a decade. Credit valuations have also come under severe pressure as markets have started to factor in the impact of slowing economic growth and higher borrowing costs on corporate earnings.
This has led to a significant re-pricing in both credit spreads and the ‘risk-free’ rate (as represented by government bond yields). Investment grade bond yields are now at multi-year highs, with five-year US investment grade corporate bonds yielding 6.2%. Notwithstanding the challenges facing the global economy, we believe these levels represent highly attractive value for bond investors, both in absolute terms and relative to other asset classes.
Credit spreads are already pricing in a severe recession and a meaningful uptick in corporate defaults. While we expect the global economy to continue to slow over the next year, we do not think the contraction will be anywhere near as severe as what markets are currently pricing in. In particular, we think that the very low levels of unemployment, healthy consumer balance sheets and government support packages should limit the severity of any economic downturn.
Furthermore, corporate balance sheets are generally in good shape in our view, with many businesses having limited re-financing needs in the near-term. While careful credit analysis and a focus on fundamentals are always crucial, we think most companies should be well-placed to withstand even a more protracted economic slowdown.
We therefore believe that markets are more than pricing in the bad news, and that investors are well-compensated for taking credit risk. This is especially the case in the investment grade space, where credit spreads reflect an implied default rate well in excess not only of average default rates, but also of the worst default rates.
In contrast to the sell-off during the pandemic in 2020 – which was almost entirely driven by a spike in credit spreads - this year’s sell-off in investment grade corporate bonds has been the result of a re-pricing in both spreads and government bond yields. For investors, this provides a more balanced mixture of credit and interest rate exposure, which we believe should offer greater resilience to withstand a variety of economic environments.
As well as offering attractive value in absolute terms, we believe corporate bonds also represent good value relative to other asset classes, such as equities. A common way to gauge the relative value of bonds and equities is to compare the yield to maturity on bonds against the earnings yield on equities (the inversion of the price earnings ratio). Comparing USD BBB rated corporate bonds against the S&P 500, we can see that corporate bonds are yielding more than equities for the first time since the financial crisis, indicating potential value in the former.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.