Fixed income
Window into Fixed Income: 5 key reasons why we still like corporate bonds
4 min read 17 Aug 23
As active fixed income investors, it is normal for our views to differ from the consensus. At the moment, one of the areas where we deviate significantly from other market participants is that we believe a sharp economic downturn can still be avoided. This view is in stark contrast to the forecasts of many economists, who have been predicting a recession for some time now, often on the basis that almost all recent US Federal Reserve monetary tightening cycles have ended with a hard landing. While that may be true, in our view there are compelling reasons to believe that this time is likely to be different. We highlight these reasons below and list why in our view investing in corporate bonds still makes sense.
1. The global economy is still very strong
The global economy is currently quite strong. This is best exemplified with unemployment rates at multi-decade lows in many developed markets. In addition, in the US there are currently over 10 million job openings, which equates to almost 2 available jobs per unemployed person. This pool of available jobs should help to absorb future layoffs if economic growth declines further. Many employers also had difficulties hiring new joiners after the pandemic and may be reluctant to let workers go. We believe that the current tightness of the labour market makes the economy more resilient to absorb any future shocks.
Source: Bloomberg, 31 May 2023
2. Inflation will continue to come down over time
The main problem for global financial markets at the moment is inflation. Central banks started hiking rates in developed markets 12 to 18 months ago, and we are only starting to feel the full effects now. This should result in lowering demand and lower inflation over time. In addition, we believe inflation is at least partially a function of the supply of money. Quantitative easing created inflation during the pandemic, and therefore the removal of the excess money supply and quantitative tightening will help to bring down inflation, potentially even lower than many expect. In our view, an environment where growth remains resilient and inflation declines meaningfully is likely to be positive for risk sentiment and corporate bonds.
Source: M&G, Bloomberg, Fed Z-1 financial accounts, 31 May 2023. M2 is a classification of money supply. It includes M1 – which is comprised of cash outside of the private banking system plus current account deposits – while also including capital in savings accounts, money market accounts and retail mutual funds, and time deposits of under $100,000. M2 is a broader classification than M1. Information is subject to change and is not a guarantee of future results.
3. Investor demand for corporate bonds to remain strong
In our view, the demand for corporate bonds is likely to remain strong given the elevated level of yields that have been on offer. This is true both in absolute terms and also relative to other asset classes, such as equities. For example, for the first time since the global financial crisis, the yield on BBB rated US corporate bonds has been higher than the earnings yield on the S&P 500. This bodes well for corporate bonds, as more investors could now be able to meet their return aspirations by investing in high quality credit.
Source: Bloomberg, 29 May 2023. *trailing 12m Earning Yield
4. Potentially less supply of corporate bonds going forwards
In the past, financial repression and the record low levels of interest rates were strong incentives for companies to issue more debt in order to engage in aggressive corporate behaviour, for example through M&A activity or equity buybacks. By contrast, in an environment of higher interest rates, companies are likely to be more conservative and maintain stronger balance sheets. This shift is already observable in the total face value of US Dollar corporate bonds over time, which after having grown steadily for many years and then surged during the pandemic, has now levelled off. With the possibility of lower structural supply of corporate bonds in the near future and still strong demand from investors due to the potential for attractive yields, we believe the asset class could perform strongly going forwards.
Source: Bloomberg, 31 May 2023
5. A more stable interest rate environment could be favourable for corporate bonds
Last year was characterised by surging inflation and central banks hiking interest rates at breakneck speed. This resulted in weak performance for government and corporate bonds, as prices adjusted to higher yields. This environment also caused the ICE BofA Merrill Lynch MOVE index, which reflects investors’ expectations about future volatility in US Treasuries, to increase dramatically. Now that the vast majority of the rate hikes are behind us, we expect the MOVE Index to shift downwards as rates uncertainty subsides somewhat over time. Given the positive and strong relationship between the MOVE index and corporate bond spreads historically, this could lead to the outperformance of corporate bonds in the event that spreads tighten.
Source: Bloomberg, 29 May 2023. US HY spreads from CDX NA HY Index
The value and income from the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise and you may get back less than you originally invested. There is no guarantee that the fund will achieve its objective and you may get back less than you originally invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast.