5 key reasons why we still like corporate bonds

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.  

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.

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.

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.

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. 

M&G (Lux) Optimal Income Fund

A resilient economy, declining inflation and the current strong appeal of corporate bonds has led us to maintain a sizeable allocation to credit within the M&G (Lux) Optimal Income Fund this year. Of course, we remain highly selective, with a bias for stronger companies where default rates are likely to stay very low. This is reflected in the fund’s positioning, which is invested 70% in investment grade and only 30% in high yield. If volatility should pick-up again, we believe maintaining a higher average credit quality can offer natural diversification and a source of resilience during uncertain market conditions. Overall, a global, flexible and selective approach to corporate bond investing will be key to unlocking returns in the future.

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.

• Investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the fund. 
• High yield bonds usually carry greater risk that the bond issuers may not be able to pay interest or return the capital. 
• The fund may use derivatives to profit from an expected rise or fall in the value of an asset. Should the asset’s value vary in an unexpected way, the fund will incur a loss. The fund’s use of derivatives may be extensive and exceed the value of its assets (leverage). This has the effect of magnifying the size of losses and gains, resulting in greater fluctuations in the value of the fund. 
• Investing in emerging markets involves a greater risk of loss due to greater political, tax, economic, foreign exchange, liquidity and regulatory risks, among other factors. There may be difficulties in buying, selling, safekeeping or valuing investments in such countries. 
• The fund is exposed to different currencies. Derivatives are used to minimise, but may not always eliminate, the impact of movements in currency exchange rates.
• Further details of the risks that apply to the fund can be found in the fund's Prospectus.