January 9, 2023 |
Fixed Income Macro Views
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NAVIGATING OPPORTUNITIES IN INVESTMENT GRADE CREDIT
Navigating Fixed Income
March 1, 2023 | 9 Minute Read
Bottom Line
We believe the deep and diverse universe of investment grade (IG) corporate bonds can provide investors with a stable source of income to achieve investment goals over various time horizons. At the same time, the asset class provides exposure to typically well-established companies, some of which are helping to drive the digital revolution, energy transition and inclusive growth.
The Case for IG Credit
A High-Quality Source of Income
The US and European IG credit markets provide a healthy yield of 5.4% and 4.1%, respectively.1 We believe this is an attractive source of predictable income that can help investors achieve medium- to long-term investment goals (Exhibit 1).
Exhibit 1: Income and Total Return Potential is the Most Attractive It Has Been in More Than a Decade
Source: Macrobond, ICE BoFAML. As of February 16, 2023. Pre-pandemic average reflects 2009-2019.
Capital Preservation in an Age of Uncertainty
Investing in IG credit involves lending to resilient and often well-established companies that typically honor coupon and principal payments. In other words, the potential for capital loss or defaults owing to credit risk is low. And though the asset class is sensitive to duration risk, we believe its high quality is important in an age of uncertainty, and as investors face inflection points including a shifting economic landscape, new geopolitical alliances, accelerations in the adoption of new technologies, and the energy transition.
A Deep and Diverse Investment Opportunity Set
There are over $12 trillion worth of corporate bonds in the global IG credit universe comprised of bond issuers from 59 countries.2 This diverse geographical footprint means investors can capture outright and relative investment opportunities across regions. The investment opportunity set is also characterized by various bond maturities, allowing investors to achieve investment goals over various time horizons (Exhibit 2). Further, the broad spectrum of bonds available in the asset class enables investors to position along the credit curve depending on the interest rate outlook. For example, recession fears have led to inverted credit curves. As a result, short- and intermediate-maturity bonds exhibit a more attractive carry-and-roll profile relative to longer-dated bonds.
Exhibit 2: Investors Can Gain Broad Geographical Exposure and Move Up and Down the Maturity Ladder
Source: Bloomberg Global Aggregate Corporate Index. As of February 15, 2023. For illustrative purposes only.
Why Now?
Total Return Potential is at a Decade High
When yields were low—or even negative—high quality bond yields faced constraints from effective lower bounds during risk-off episodes. But after a painful adjustment to higher yields in 2022,3 IG credit now offers the most attractive level of income in more than a decade. In fact, total return potential is at the high end of its historical range, especially by the standards of the post-global financial crisis period. This higher yield—or income—can offer shelter during risk-off moves but also help to offset declines in bond prices should rates rise further. A slower pace of monetary tightening also implies lower rate volatility which is further supportive of “low beta” pockets of fixed income markets like IG credit.
Macro resilience, firm credit fundamentals and supportive technicals have already helped IG credit deliver decent positive total returns year-to-date (Exhibit 3). As a result, we now consider IG credit spreads to be consistent with a fair level of carry and roll,4 a component of excess returns which tends to dominate over time.
Exhibit 3: The Tide on Total Returns is Already Turning
Source: Macrobond, based on ICE BoFAML indexes. As of February 17, 2023.
Resilience to Downside Growth Risks
Except for the UK, most major economies look set to avoid recessions in 2023. But even if recessions are avoided, growth will likely remain below trend and earnings growth among corporates is decelerating. Against this backdrop, we would expect IG corporate bond issuers—whose credit fundamentals remain healthy—to prove more resilient relative to more cyclical assets like equities, in line with the historical trend (Exhibit 4).
Momentum in credit rating actions has been positive for almost two years, with the notional amount of rising star bonds (upgrades from high yield) in the US market outpacing fallen angels (downgrades into high yield) for eight consecutive quarters.5 Even as balance sheet liquidity positions normalize towards pre-pandemic levels, we expect fallen angel activity to remain contained under most economic scenarios, including a hard landing. This is due to the strong starting point of balance sheet positions and compressed timeline of the current cycle which has—in many cases—kept late-cycle behaviors that can lead to a deterioration in credit quality at bay. As a result, the attractive yield delivered by the asset class largely stems from high quality issuers and is not being skewed higher by weaker credits on the verge of downgrade into the high yield market.
Furthermore, the sector composition of IG credit indexes tends to be tilted towards defensive sectors like energy, defense, consumer staples and high-quality financials, further diminishing sensitivity to downside growth risks. Taken together, firm credit fundamentals and low cyclicality relative to other assets suggests limited spread widening in 2023—particularly in relation to prior growth downturns—as credit concerns remain in check.
Exhibit 4: IG Credit Tends to Exhibit Resilience During Equity Market Drawdowns
Source: Goldman Sachs Asset Management, based on Bloomberg indexes.
Supportive Technical Dynamics
With most companies tapping capital markets to raise debt while interest rates were low, near-term refinancing needs are limited. For example, only around 16% of US IG corporate bonds mature in 2023 and 2024.6 A subdued new supply outlook combined with robust demand from yield-oriented investors paints a positive technical picture for the asset class. Demand for IG credit started to trend upwards at the end of 2022 as investors began to rotate back up the quality spectrum. Inflows into the asset class have maintained positive momentum into 2023 (Exhibit 5) and still-light positioning relative to pre-COVID levels suggests demand may rise further, prolonging the positive technical impulse for performance.
Exhibit 5: Investors Regain Appetite for High Quality Fixed Income Assets Amid Higher Yields
Source: Morningstar, Goldman Sachs Asset Management. As of January 2023.
Where are the Opportunities?
In the absence of ever-lower interest rates and in the presence of greater macro uncertainty we expect active bond selection alongside dynamic sector allocation to be an increasingly important driver of alpha generation (Box 1). Below we highlight three high-conviction investment views:
Relative Value: Lower Quality Bonds Within a Higher Quality Asset Class
The BBB-rated part of the IG credit market is the lowest quality but largest and most diverse rating cohort. In our view, this deep investment opportunity set provides attractive income for solid fundamentals. Notably, BBB-rated issuers appear to be managing capital conservatively, and have maintained some cash flow after capital spending, dividend payments and share buybacks.
Sector Spotlight: Banking on Banks
In 2022, excess savings deposits coupled with an increase in loan growth required banks to raise capital in line with regulatory requirements. The resultant increase in new bond supply saw corporate bonds issued by banks accumulate more spread premium relative to other sectors. In our view, spreads appear wide relative to resilient credit fundamentals; the banking sector is well capitalized, while robust lending standards and healthy private sector balance sheets implies loan books are in good shape. Further, many banks have built-up provisions in event of losses on loans. In addition, higher rates point to an improved outlook for net interest margins. The sector is also geographically diverse and can cater to various investor appetites, with investors able to gain access to the various parts of a bank’s capital structure. Overall, attractive valuations—as reflected by wide spreads—combined with strong fundamentals leads us to be overweight the bank sector.
Thematic Lens: Telecoms – Internet Explorer
The internet has become an essential tool for powering the global economy, with lockdowns turbocharging demand for video conferencing and telemedicine alongside online gaming, education, and learning. As providers of high-speed internet, companies in the telecommunications (telecoms) sector are at the center of the digital revolution. High investment needs lead to high debt issuance within the sector, and in recent years, debt-funded M&A activity has placed many companies in the BBB-rating cohort. We seek to select bonds issued by companies with robust credit fundamentals that are well positioned for the industry’s crosscurrents. For example, in the past, we favored cable companies that delivered internet access through dial-up modem, as this reflected an improvement on phone line links provided by telecoms. However, today, we see greater investment potential in telecoms that are providing broadband internet via wireless fiber networks and 5G based wireless products.
Fiber is arguably the leading technology currently capable of delivering the speed and capacity of internet required by households, businesses, and governments. It is also considered an energy-efficient solution to growth in internet traffic as more usage shifts towards mobile devices. According to company data and industry reports, Fiber is 80% more energy efficiency than copper networks used by cable providers, making it a key solution for helping the telecom sector grow while reducing its carbon footprint (Exhibit 6). Indeed, the use of proceeds for a recent green bond issued in the sector are intended for fiber expansion.
Some Telecom companies offer basic broadband internet access through Fixed Wireless Access (FWA), taking advantage of existing wireless spectrum holdings as opposed to a physical connection to the premises. This offering’s internet speed is not as fast as fiber or cable, though it can be more cost-effective. This price competition is leading incumbents to expand internet coverage in rural areas and disadvantaged areas, which we believe can help to narrow digital divides and advance inclusive growth. Looking ahead, we suspect the sector may encounter further disruption as new competitive technologies emerge and as the policy backdrop evolves. We stand ready to refresh our internet explorer investment tab accordingly.
Exhibit 6: More Connected Devices, More Internet Demand
Source: Goldman Sachs Global Investment Research GS Sustain. As of August 16, 2022.
BOX 1: THE NEW ALPHA-BET
From Goldilocks to the Three Bears
In the last cycle, a ‘Goldilocks’ regime of not too high or too low growth and inflation allowed central banks to buffer—and elongate—the cycle. Indeed, the last US expansion was one of the longest on record. Furthermore, a wave of liquidity and a downtrend in interest rates helped to lift all assets, with limited performance dispersion both across and within asset classes. For example, corporate bonds in a particular sector generally performed in line with each other despite differences in company-level balance sheet positions. In 2022, this setup was disrupted by high inflation and aggressive monetary tightening. Going forward, even as inflation peaks and the pace of policy tightening slows, we think investors will need to navigate three bearish factors:
- Higher inflation stemming from structural shifts such as de-globalization in goods and labor, demographic aging, decarbonization, and destabilization in geopolitics.
- Tighter policy given firmer inflation and high government debt levels.
- Growth volatility reflecting macro, political and policy uncertainty alongside the risk of supply side shocks in tight commodity markets.
Investment Implications
In our view, this backdrop will give rise to a new investment “Alpha-Bet” characterized by:
- Greater bond-level dispersion that requires active security selection to distinguish borrowers based on their ability to adapt to slower economic and earnings growth, as well as a higher-for-longer inflation and rate environment.
- More risk premium stemming from left-tail risks driven by economic, geopolitical and industry shifts which can give rise to tactical investment opportunities.
- Shorter cycles which require a dynamic approach to asset and sector allocation.7
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