Our corporate bond outlook for 2023
2022 has been an annus horribilis for corporate bonds, with no developed-market (DM) segment posting positive total returns year to date. High-yield (HY) bonds have fared better than investment-grade (IG) ones, as the former have been less penalised by rising rates, in part due to their higher coupons. Nevertheless, since the beginning of November total returns have improved all round, helped by falling government bond yields and tighter credit spreads.
There have been increasing signs that the US and Europe will enter into a recession early next year. The US Institute for Supply Management (ISM) survey for manufacturing activity dipped into contraction territory (i.e. below 50) in November, while US banks are imposing highly restrictive lending conditions on firms. These are usually two reliable harbingers of recession in the US. Ahead of past recessions, US HY spreads levels have typically reached around 800 bps, compared with below 500 bps today. This discrepancy, coupled with the recent surge in HY companies’ borrowing costs, has us worried that credit markets are not offering sufficient protection against the risk of rising defaults.
We therefore expect US and euro HY spreads to widen significantly later next year, to 680 and 800 bps, respectively. Nevertheless, until the expected recession damages companies’ profitability, HY credit spreads are likely to remain range bound as some market participants are keen to lock in historically attractive yields, hoping that companies will be able to weather a mild recession. But until we have more clarity on the severity of the emerging cyclical downturn, we remain underweight HY bonds in general.
Even if HY yields are juicier, short-term US and euro IG bonds offer attractive coupons for buy-and-hold investors without having to take on too much duration or credit risk. Moreover, IG bonds have historically fared better than HY in times of economic recession and rising default rates. These are considerations not to be ignored in today’s volatile fixed-income markets and uncertain economic environment. As such, we remain neutral US IG corporate bonds and have recently moved from underweight to neutral on their euro counterparts.