Investment Grade Corporate Credit 3Q24 Outlook

• Investment grade credit fundamentals have weakened somewhat but overall remain healthy
• We remain constructive on H2 returns as lower rates should offset any spread widening
• Our portfolios are positioned with a modest carry advantage, over-weight regional banks and positioned for a steeper yield curve
   

At the start of 2024, we anticipated range-bound spreads with interest rates declining as the year progressed. Contrary to these expectations, however, in the first half of 2024 the market saw tighter spreads and higher interest rates. Despite this, we remain constructive on total returns for the full year. Even if, as we expect, economic growth slows somewhat and spreads were to widen modestly, we still expect full year returns to be attractive, with lower interest rates in the second half of the year more than offsetting any widening in credit spreads.

Figure 1: Corporate Index Return Composition (%)

Source: Bloomberg

What to watch for in H2 2024

As bond investors we are generally predisposed to look at risk from a downside perspective, not least as corporate bonds have all the upside of par and much of the downside of equity. We think credit spreads face some headwinds in the second half of 2024. The month of June illustrated how swiftly declining U.S. Treasury yields can weigh on investment-grade credit spreads as Treasury yields fell more than all-in corporate yields. In a scenario of softening labor and inflation data, falling Treasury yields would likely reduce the attractiveness of fixed income investments, slowing inflows into the asset class from yield-seeking investors such as pension funds and, at the same time, reducing the attractiveness of U.S. fixed income markets to foreign investors as local currency alternatives may become relatively more attractive. This set-up could be magnified by previously-sidelined issuers entering the new issue market, especially the longer tenor market, to take advantage of all-in lower yields to issue debt. This means that spreads could drift wider from the current 90-100bp range.

Figure 2: Corporate OAS (bp) vs 10-Year Treasury Yields

Source: Bloomberg

There are some notable factors that lead us to be more vigilant around the direction of credit spreads in the second half of 2024 and lead us to believe credit spreads are, at best, likely to remain rangebound. First, the pace of flows into investment grade is slowing. The first half of 2024 saw inflows of $176bn into investment grade bond mutual funds and ETFs, using data from JP Morgan. This translates to around 5% of the total assets under management as of the start of the year. Importantly, 69% of this inflow came in the first quarter, which means flows slowed in Q2 2024. This typically follows a period of rising interest rates, which is precisely what we saw in Q1 as conviction regarding rate cuts later in the year waned. As Q2 progressed, softer labor and inflation data rekindled rate cut expectations, although members of the Federal Reserve continue to reiterate their data dependency.

This volatility in rate cut expectations may temper any significant moves in spreads due to flows until investors gain more conviction, which may not be until after the first rate cut. At the same time, as mentioned above, lower rates also reduce the overall attractiveness of investment grade and could spur investors to allocate to other asset classes with greater return potential.

The second factor holding our attention is receding credit fundamentals. Credit fundamentals are still solid, but they have weakened over the last few quarters. We expect neither the economy nor credit fundamentals to materially weaken. Nonetheless, it is worth noting that credit trends are turning downward. Our research indicates that negative EBITDA growth combined with higher interest rates is driving interest coverage ratios lower as companies issuing new debt or refinancing existing debt are doing so at significantly higher interest rates than just a few years ago. We estimate that newly issued debt carries an average coupon of 2% more than existing debt, driving interest coverage ratios to the low end of their five-year range. Reflecting weakening earnings, companies have responded in a creditor-friendly way by reducing share buybacks and dividends as well as slowing the pace of capital expenditures.

Credit rating trends remain strongly positive, though we view changes in credit ratings more as a lagging rather than a leading indicator. For the year thus far, upward ratings momentum in the investment grade space has been strong, with the upgrade/downgrade ratio at a record 4.8x, translating into almost 5% of the investment grade market being upgraded in 2024 on a net basis. Trends matter when investing; perhaps more critical is spotting changes in trends. A change in this trend may become more evident as we go through 2024. Last year, 8% of the market was upgraded, and 7% was upgraded in 2022. This all means that the composition of the investment grade market has been improving, with BBBs now 46% of the index, the lowest since 2015. A-rated bonds make up 45% of the index, the highest percentage since 1H-2012. We are carefully watching whether the upgrade/downgrade ratio weakens as strong credit fundamentals begin to fade.

Figure 3: Upgrades exceeded downgrads every quarter since 2021

Source: JP Morgan

Figure 4: 4.8% of HG debt was upgraded (net of downgrads) in 1H24

Source: JP Morgan

Portfolio Positioning

Despite our view that investment grade valuations are likely to be range bound, there are areas of the investment grade market that appear attractive. US regional banks’ credit spreads still remain wide on concerns around possible credit rating downgrades, commercial real estate risk (primarily from office properties) and the inverted yield curve. With regional banks’ credit spreads 50 basis points wide of the larger and higher-rated money center banks, and with the prospect that larger regional banks may be forced to issue less debt to comply with new regulations, we expect this gap to close over the next 12 months (regionals have historically traded inside of money center banks). It is noteworthy that the financial sector has significantly outperformed the industrial sector to date.

Figure 5: Money Center Banks Vs Regional Banks: Credit Spreads

Source: JP Morgan

We remain underweight the long end of the market and overweight short and intermediate debt. The yield curve remains inverted and compensation for extending maturities beyond 10 years is not justified by current valuations in our view. In addition, as we expect markets to become more certain of rate cuts going forward, we would then expect the yield curve to steepen. This positioning allows us to earn positive carry, and eventually profit from what we see as an inevitable normalization of the yield curve. 

Looking ahead into the second half

We remain cautiously constructive on investment grade credit and believe that the asset class offers relatively stable carry with yields of approximately 5.5%. With credit spreads at or near historical tights, signs of a slowing economy, technicals somewhat less certain and the potential for volatility surrounding the presidential election, we view credit spreads as more likely to widen modestly in the coming months. At the same time, we have growing confidence that we will likely see several rate cuts before the end of this year. Accordingly, we believe it likely investors will earn the carry with a small probability of additional price appreciation from lower interest rates.