Are corporate credit markets at once-in-a-generation yields?

Rare dislocations create openings

A very rare dislocation has arisen in markets between inflation and growth. Inflation is proving very high in the short term, whereas longer term growth is trending downward. What does this mean for fixed income investors?

Going forward, we strongly believe both growth and inflation should moderate from here, even if inflation overall will remain higher than levels seen over the past decade. The extent of the expected decline in growth and inflation by 2024 is key for fixed income investors to decide whether current yields are rewarding them sufficiently for the risk they are incurring. In our view, there is little scope for further upside pricing in inflation from current levels and benchmark government bond yields are particularly compelling.

The selloff has left high-quality yields perched at elevated levels that could prove favourable for corporate bond investors with a long-term investment outlook. Indeed, the severity of the selling has created extremely attractive valuations, in our opinion. In particular, entry points for global investment-grade (IG) corporate credit hedged in US dollars, Asia IG credit and EUR Crossover¹ are at elevated levels that we do not expect to persist indefinitely, and should therefore be taken advantage of by mid- to long- term investors.

Inflation set to decline

We believe inflation has peaked in the US and will peak in Europe in the coming months. The market is pricing in long-term US inflation at about 3% over the next decade² in a brutal selloff that has pushed US Treasury (UST) 10-year yields just north of 3%. Yet markets have yet to take a through-the-cycle view of UST price action.

In the short-term, we expect US inflation to recede for the following reasons:

• Covid-stimulus to US consumers has ended
• Wage increases are unable to keep pace with rising inflation; real wages are negative and there is a lack of excess disposable income to fuel further inflation
• Mortgage rates have risen and lowered affordability, which should cool the housing market
• Future inflation readings will be compared to the current, higher base, therefore limiting rises
• The Federal Reserve is tightening monetary policy
• China is expected to re-open and alleviate supply-chain bottlenecks

In Europe, the market expects CPI levels to peak around mid year to end Q3³. The firmer inflationary picture is mainly resulting from pass-through effects from the Ukraine/Russia conflict and supply-side shocks. We believe that once such pressures subside, however, a lack of structural demand drivers will lead to inflation easing, especially as wage pressures remain soft. Similar to the US, markets are yet to take a through-the-cycle view of Bund price action.

In the short-term, we expect Eurozone inflation to peak soon due to the following drivers:

• Tightening financial conditions
• The economic recovery proving incomplete, and the output gap being negative, neither of which will put pressure on inflation
• Nominal wages being stuck at low levels and real wages being deeply negative, therefore preventing an increasing wage/price spiral
• While energy inflation may persist in the coming months, further shocks are required for additional energy-price-driven inflation
• Supply-chain bottlenecks are creating goods inflation but are expected to ease once China reopens and demand shifts to services
• Mortgage rates are increasing and lowering affordability
• Future inflation readings will be compared to the current, higher base, therefore limiting increases

Longer term, structural factors are also at play in both the US and Europe. For instance, debt levels are high and will continue to rise. Peripheral Eurozone sovereigns face particular challenges in this area. Furthermore, productivity in both areas is unlikely to boom due to the depressed capex cycle of the past decade.

The global discourse on inflation has already begun to shift towards vulnerable growth. Economic expansion is showing signs of weakness, with economic surprise indices falling from February peaks across the board, though our central scenario is for slowing growth (rather than recession) in the US and Europe. We believe central bank tightening will successfully tame inflation, but it will also cause flagging growth that will eventually overshadow inflationary concerns in the future.

What about yields?

Given our outlook for diminishing inflation, we believe the market has gotten ahead of itself in pricing in rate hikes: UST yields in particular have overshot their long-term fair value here. Yields are high as a result of markets ‘front loading’ the cycle of rate hikes into prices, and due to the uncertainty around the exact peak in rates. Over time, we expect such dislocations to correct, though that ride is likely to remain choppy and volatile.

Regardless, UST and Bund yields are now higher than historical rolling returns (see figure 1), making potential returns more attractive for investors.

Figure 1.  Government bond rolling returns vs yields – US and Eurozone

Source: Bloomberg as at 25 April 2022. For illustrative purposes only. . Yields are subject to change and can vary over time. Past performance is not an indicator of future returns.

Yields of high-quality corporate debt also benefit from the added yield pickup, as well as the added premium from wider spreads, and now stand at the upper end of ranges seen since the financial crisis in 2008 in global IG debt and Asian hard-currency-denominated IG debt.

Figure 2. IG corporate index yields (to worst, USD hedged)

Source: Bloomberg as at 9 May 2022. For illustrative purposes only. Yields are subject to change and can vary over time. Past performance is not an indicator of future returns. Bloomberg Barclays global corporate IG index used for Global IG, JP Morgan JACI index spreads used for Asia IG.

On a cross-asset basis, corporate credit also appears attractive with the yield-to-worst on US corporate similar to the S&P 500 earnings yield.

Figure 3. US IG yield relative to S&P 500 earnings yield

Source: Bloomberg, LOIM as at 6 May 2022. For illustrative purposes only.

A window of opportunity

Yields currently reflect the market pricing in a substantial amount of inflation. Long-term investors should take advantage of this by averaging into their fixed income allocations. Pronounced volatility is highly likely to persist in the near future, making us proceed with caution regarding any short-term calls. That said, yields in global IG corporate (hedged in USD), Asia IG corporate and EUR Crossover are at levels not seen in over a decade.

Windows of opportunity can shut as quickly as they open: current levels represent a strong multi-year opportunity that may not exist again for fixed income investors.

Sources

[1] Crossover refers to corporate bonds rated BBB to BB. Yields are subject to change and can vary over time. Past performance is not a guarantee of future results.

[2] Sources: Bloomberg, Markit as of May 2022. Refers to prices of the USD 1y forward inflation swap.

[3] Source: Bloomberg, as at 6 May 2022.

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