Fixed Income Quarterly – Corporate bonds: a brighter outlook as clouds lift (2024)

We expect global corporate bonds to be supported in 2024 by a soft landing in the major developed economies and easier monetary policy. Overall, we believe company fundamentals are robust, particularly in the investment-grade market, with high cash levels, low leverage, and encouraging earnings expectations.

While these and other metrics are likely to deteriorate in 2024 as global growth continues to slow, many companies have entered the year at a relatively good starting point. In our view, such sound fundamentals should help carry the asset class through another period of uncertainty.

Additionally, a supportive technical environment is likely to be a tailwind for the corporate bond market. We continue to see sturdy investor demand for both investment-grade (IG) and high-yield (HY) bonds, in part due to their high absolute yields. These yields can provide a substantial buffer to total returns should we see periods of rising sovereign bond yields or credit spread widening.

While investor positioning in the US IG market is creating a risk of greater sensitivity to changes in the outlook, we expect declining capital market volatility and, more broadly, improving liquidity to provide a counterbalance to what may be an already crowded trade.

Positive on US investment-grade corporate bonds

In our view, slower primary market issuance and high inflows, particularly driven by domestic demand, should be supportive of US IG corporate bonds, even if the competition from still-high cash yields and other IG asset classes remains. In the coming quarters, cash yields are likely to fall, and other IG asset classes normalise.

We believe the potential for capital appreciation is limited given the market’s strength in the final months of 2023 and the asset class’s relatively flat yield curve. But, in our view, the carry in US IG is attractive enough. Yields have fallen from an October 2023 peak near 6.4% to around 5% at year-end, but remain high relative to their averages since the Global Financial Crisis.

We currently see more value in

• financials (global systemically important banks, non-office real estate investment trusts, finance companies)
• domestic telecommunications
• food & beverage sectors.

We are cautious on pharmaceuticals given the legislative risks, competition from generic drugs, and the risks of mergers and acquisitions.

We are also guarded on the transportation sector, given the economic slowdown, as well as sectors more exposed to consumer weakness. Consumers have been drawing down their excess savings while credit card balances and car-loan delinquencies have been rising.

Neutral and opportunistic on US high-yield credit

The fundamental outlook for US HY is decidedly mixed, in our view. End-investor demand is slowing and funding costs have remained high, but companies have generally positioned themselves for slower growth and a lower dependence on liquidity. Nevertheless, we think default rates are likely to rise while credit ratings are already drifting moderately lower.

We believe higher-quality credit segments will perform better. What an investor may stand to lose in beta exposure can be made up in higher coupons and less volatility from having a reduced exposure to companies showing a more pronounced refinancing risk.

The sector nonetheless bears watching. We believe many investors are substantially underweight the high yield sector, so should the US economy show more convincing signs of recovery, a reversal of sentiment could be followed by a significant inflow of funds, pushing spreads lower.

Eurozone investment-grade: Positive (and more so than US IG)

As is happening in the US, eurozone corporate fundamentals are generally deteriorating and will likely continue to do so, but from a high starting point. The significant levels of cash held by many eurozone IG companies, for example, suggests they are well positioned to weather slower growth.

However, EU IG bonds differ from their US counterparts in their valuations. Despite a recent narrowing, EU IG spreads have remained historically wide. This is in part due to changes in the overall structure of recent bond issuance, with more subordinated debt from banks and other corporates. But justifiably higher spreads in these lower credit-quality segments have been putting upward pressure on the higher-quality segments, making them attractive on a risk-adjusted basis.

At the sector level, we prefer banks since we have a positive outlook on eurozone banks and see valuations as compelling relative to those of other sectors. However, we also expect a greater dispersion between banks themselves.

We see attractive valuations at the lower end of the IG spectrum, particularly in non-cyclical sectors such as utilities, telecommunications and discretionary consumer sectors.

Defensive & selective on European high-yield credit

We prefer defensive allocations within EU HY, favouring the higher end of the credit spectrum. However, we do see attractive opportunities at an industry and issuer level.

While lower-rated bonds in the financials sector can offer attractive yields, we see more value in higher-rated issuances. For example, AT1 paper in the banking sector, or selected bonds that mature in 2025 or 2026, but have low refinancing risk, may offer compelling risk-adjusted returns. We also like higher coupon issues in selected high cash-generating businesses that are better positioned to weather the slowing growth.

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