Talking Heads – La protección que ofrece la deuda estadounidense de grado de inversión

This is an audio transcript of the Talking Heads podcast episode: Consider the ‘cushion’ of US investment-grade bonds

Daniel Morris: Hello and welcome to the BNP Paribas Asset Management Talking Heads podcast. Every week, Talking Heads will bring you in-depth insights and analysis on the topics that really matter to investors. In this episode, we’ll be discussing the US investment-grade market. I’m Daniel Morris, Chief Market Strategist, and I’m joined today by Yrieix de James, US Investment-Grade Portfolio Manager. Welcome, Yrieix, and thanks for joining me.

Yrieix de James: Thanks, Daniel. Great to be here.

DM: When we consider the US investment-grade (IG) market, we are more or less through the earnings season, and it seems to have been pretty good – the surprises were quite positive and above average. We see companies doing better than expected and generally reasonably optimistic about the outlook. I think you’re going to talk about how investment-grade bond spreads reflect that perspective. But let’s start with an overview of what’s happened so far in 2024 in the US investment-grade market and what you anticipate over the next couple of quarters.

YDJ: The US economy is still exceptional, with strong GDP growth and a slowing but resilient labour market. This has led the US Federal Reserve (Fed) to push back on its first rate cut – which markets had initially expected in March – as it fears loosening monetary policy could derail this trend and send inflation back up. That was reinforced with the most recent consumer price index (CPI) print.

On the earnings side, US companies have been a mixed bag, but overall remain healthy, with 80% beating consensus estimates. We have had the resurgence of fear around commercial real estate and its impact on banks following the news from the New York Community Bank, but overall, the backdrop has been fairly supportive for the asset class so far.

US investment-grade credit spreads have returned 0.56% over Treasuries so far this year, extending their strong performance from November and December 2023 on a total return basis. If we include movements in US rates, the performance is down by 1.57%.

Looking ahead, we expect the US IG market to remain resilient throughout this year due to still-high yield levels, but also a supportive fundamentals backdrop given the strength in the US economy and healthy corporate balance sheets, which we think will be met by strong demand from the investment community.

Some risks remain, notably elections throughout the world, and geopolitical risks. But we see US investment-grade as relatively insulated compared to other parts of the developed world. Also, we are cognizant of where we are in terms of valuations and the risk of seeing more mergers and acquisitions and shareholder-friendly operations from corporates in the context of lower yields, which provides cheaper funding to undertake such operations.

This usually means some pressure for bond holders as companies allocate less capital to debt repayments. But our view is that companies’ balance sheets are healthier than they were in 2019 and their management is generally more disciplined in terms of capital. This should help prevent a massive wave of credit downgrades.

Credit spreads as a proportion of overall yield are at an all-time low. That suggests investors are not being properly compensated for taking on credit risk in US IG corporates over Treasuries. In our view, this reflects the strong sentiment around the asset class in the context of elevated yields; it doesn’t necessarily mean credit spreads should materially widen from hereon and thus underperform on the supply side.

January has been exceptionally strong, and February is on track to post another impressive figure. This is usually a headwind for credit spreads as new deals tend to be cheaper than existing debt and investors sell existing debt to fund the purchase of new debt. Both these elements lead to wider credit spreads and negative performance.

But this time around, supply has been met with an even stronger demand, offsetting that weakness I just mentioned. We expect supply for the year to end slightly below last year’s level, mainly driven by corporates, while financials – especially banks – should run flat versus last year as they refinance maturing debt first and then face mounting pressure from the regulator to increase their capital.

The strong demand for US investment-grade can also be seen in the healthy flows into the asset class so far this year. We view US investment-grade as an attractive asset class in 2024 thanks to the healthy fundamental backdrop, strong demand and elevated yield that provides some cushion.

DM: On the one hand, you’re anticipating decent supply in terms of corporate issuance and investment-grade debt, but offsetting that you anticipate good demand. What drives that demand for the asset class and how you anticipate that evolving in 2024?

YDJ: Historically, demand for US IG credit mainly comes from domestic insurance companies. That includes life insurers and property and casualty insurers, but also pension funds and foreign investors, particularly from Asia. The latter has seen the most rapid expansion over the last 10 years, while life insurers saw the largest fall in demand from mutual funds.

So, the retail part of the market is rather small compared to the rest, at around 18%-20% of overall demand. However, it has increased over the year as higher yields made the asset class attractive again after a mixed 2023. From a demand standpoint, the start of 2024 has been supportive, with strong inflows into the asset class. We expect demand to remain robust throughout the year in an environment where growth slows, [interest] rates fall, and cash becomes less attractive than credit. This should help to support credit spreads.

Demand has been particularly strong in long duration bonds due to a combination of low supply, which increases the value of such bonds through scarcity, but also high yields and strong incentives from so-called yield-oriented investors to lock in an attractive long-term income.

We think that this is likely to continue as long as [interest] rates remain high, but should turn as monetary policy eases. That would be to the benefit of short-term bonds at around the 10-year end in maturities.

On the other hand, investors’ focus on credit spreads rather than yield has started to suggest some nervousness given stretched valuations. But it’s abundantly clear that elevated rates contain volatility, and a supportive, fundamental backdrop is unlikely to cause spreads to move materially wider in the absence of any major external shock.

DM: Within investment-grade, there are different sectors. We think about how the US economy is evolving and you mentioned commercial real estate is an area of concern. There are also worries about consumer demand, particularly as excess savings that people had accumulated with the government support during the pandemic runs out. Taking all that into account, what parts of the US investment-grade market do you find the most interesting?

YDJ: We expect the asset class to remain resilient. Valuations are important, but we like sectors that have performed through the cycles or that have stronger balance sheets and are in a better position now than they were a few years ago. This includes financials, starting with banks and notably the largest ones in the US and Europe, but also large US regional banks.

We also like real estate investment trusts [REITs], which still look cheap and allow us to select the assets we like the most. Given the large number of issuers in that sector that are operating across many different markets outside financials, we think the highest-rated part of the corporate segments doesn’t look that attractive from a credit perspective.

This is a reflection of investors having moved up in quality through 2023, especially in longer duration bonds. But we still like the parts of the markets that are mostly defensive, as it can provide some downside protection in a scenario where US investment-grade is under pressure.

Beyond that, we like BBB [rated] corporates, especially issuers in sectors which have shown discipline in reducing debt and increasing cash flow, but that are still quite cheap versus their higher-rated counterparts. These companies should outperform in a context where the economy slows down without the US entering a full-blown recession.

We also tend to favour companies more exposed to the US. Given the strength in the economy, I think increasing the income component of returns rather than depending more on market price appreciation makes sense and we have recently favoured bonds with higher coupons to optimise returns.

DM: Yrieix, thank you very much for joining me.

YDJ: It’s been my pleasure.