As inflationary demons dissipate what does this mean for investment grade credit?

As the inflationary impulse dissipates, bonds are once more offering sufficient compensation for inflation risk, creating an attractive entry point for investors. Appealing valuations and inefficiencies in the market also provide a supportive backdrop for investment grade credit.

July saw US headline inflation fall below 3% for the first time since March 2021. With inflation continuing its downwards trajectory, what does this mean for investment grade credit?

We believe that there is an attractive opportunity within the asset class. At the end of June 2024, all-in yields in global investment grade (IG) were north of 5%, representing an attractive entry point for investors.

“With the inflationary demons disappearing, bonds are now offering sufficient compensation for inflation risk and are looking more attractive to investors.”
 

Corporate bonds benefit from their two constituent parts – the underlying risk-free rate (the duration component) and the credit spread paid in addition to this (the credit risk premium). We are seeing the most value in the duration component, which currently makes up about 80% of the opportunity set.

A supportive macro backdrop

Inflation is the number one enemy of a bond. Bond investors seek to be compensated for two key risks – inflation risk and credit risk. One of the main reasons that bond investors suffered heavily in 2022 and for a lot of 2023 was as a result of the inflationary spike, which sent bond yields soaring as the market sold off.

One lens through which we have been looking at inflation is the money supply. A monetarist view of inflation has been out of fashion in the 21st century, but there has been a strong empirical link between the nations that printed the most money during Covid and those that experienced the greatest levels of inflation. Examples of this include Turkey and Argentina. 

The below chart shows US M2 money supply¹ plotted with an 18-month lead. The lag in monetary policy is assumed to be approximately 18 months on average, before taking effect in the real economy. You can see a strong correlation between the increase in money supply and the subsequent inflationary spike. In a similar vein, when the programme of quantitative tightening (QT) began, in conjunction with the aggressive rate hiking cycle, inflation trended down towards target.

This has created a much more supportive environment for fixed income. With the inflationary demons disappearing, bonds are now offering sufficient compensation for inflation risk and are looking more attractive to investors.

Attractive valuations – a good entry point in IG credit

Although there are some exceptions, typically bond markets overcompensate investors for credit risk within the IG space. This is certainly the case at the moment. Partly this is due to the premium to compensate for the liquidity risk in corporate bonds, which are not as easily traded as government bonds. 

The second component that corporate bond investors need to be paid for is default risk. Assuming a 40% recovery rate, the market is paying bond investors for an implied default rate that exceeds the average default rate over a five-year period, and in fact, is compensating investors in IG in excess of the worst default rate that has been experienced. This is beneficial to IG investors over those only taking exposure to government bonds, gaining some extra yield and being more than sufficiently paid for the credit risk.

2022 and 2023 were a painful experience for fixed income investors as bond markets repriced and yields sold off. Although this was a very difficult time to be a bond investor, it has created an attractive entry point to the market. 

The chart below shows the US 30-year Treasury real yield – that is, the yield on offer to bond investors, adjusted for inflation. We can see three clear time periods over the course of this chart. 

The first is pre-Global Financial Crisis, a world of less regulation and higher growth; with real yields between 1.5% and 2.5%, this was an attractive time to be a bond investor. 

The second is post-Global Financial Crisis; in this period, there was an increase in regulation and quantitative easing (QE) – which created a large buyer in bond markets forcing bond prices higher and real yields down. Real yields in this period were 0.5% - 1.5%, which represented decent value for fixed income investors. 

The third period is during Covid where there was further QE and yields were compressed even further; with negative real yields, there was very poor value on offer and bonds were expensive. The question is where will real yields settle now? Although that is not known, we can see that now is a historically attractive entry point – it is the best time to enter fixed income markets from a valuation perspective since 2010, in our view.

Opportunities for active managers – taking advantage of market inefficiencies

Within credit, there is an opportunity for active managers with a large credit analyst team to be able to beat passive peers by taking advantage of dispersion in the market. This is only afforded to those that do the credit work. The next chart shows the credit spread of different bonds in each credit rating bucket from AAA through to BB-. 

As credit quality decreases, you would expect to be paid a higher spread – the credit risk premium. For each individual rating you would logically expect to be paid the same spread, as theoretically these carry the same amount of credit risk, but we can see here that this is not the case; there is inefficiency in the market, with such levels of dispersion implying that many bonds may be mispriced.

By looking into the fundamentals of individual credits, active managers can identify the bonds that are being priced cheaply with strong credit fundamentals. Likewise, those who look at the credit fundamentals and do not rely on credit ratings can identify bonds that are given a rating that is better than their fundamentals suggest and ‘avoid the losers’, as well as identifying the bonds that are trading relatively expensively for their credit risk and instead buy a more relatively attractive bond. This gives active managers the opportunity to outperform the index and generate alpha over time.

To conclude, we believe that it is an attractive time to increase exposure to fixed income, particularly within the IG space. 

There are three main reasons for this. Firstly, the supportive macro backdrop – inflation is trending back down to target, creating a much better environment for bonds than the last few years. 

Secondly, valuations are at appealing levels. Although the repricing of the bond market was painful as yields rose, this has created an attractive entry point for investors to enter the market. With central banks at the start of the cutting cycle, exposure to the duration component will benefit as yields fall. 

Finally, the opportunity for active managers to take advantage of market inefficiencies and dispersion means that investors can earn extra yield over and above passive investments and also ‘avoid the losers’. This is only afforded to those who do the credit work rather than buying market exposure through an index.

¹ M2 money supply is the Federal Reserve’s estimate of the total money supply. This includes cash that people have available to spend, plus all money deposited in checking accounts, savings accounts and other short savings vehicles. Retirement accounts and time deposits above $100,000 are omitted (https://www.investopedia.com/terms/m/m2.asp)

The value of investments will fluctuate, which will cause prices to fall as well as rise and investors may not get back the original amount they 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.