In the US, rising Treasury yields have helped drive investment-grade corporate yields well above 10-year averages. That comes with a bonus: historically, high yields have been good predictors of forward returns.
Strong Technicals Underscore Investor Confidence
Elevated yields have had a knock-on effect by improving technical factors. In both the US and Europe, fund flows have reversed course from 2022, with high yields attracting investors to investment-grade corporate strategies in large numbers despite persistent market volatility. Ultimately, strong flows should bode well for longer-term valuations. Even if monetary policy becomes more accommodative over the coming year, we expect elevated yields to continue luring investors from the sidelines.
Technicals are also benefiting from the lack of primary-market activity so far in 2023 for investment-grade corporates. New-issue supply continues to underwhelm compared with the past few years. Supply in 2022 was about 12% lower than in 2021, and through April 2023, supply was off by 19% year over year, driven by reduced supply from financials.
Looking for the Sweet Spot
Of course, investment-grade bonds come with different risk/return profiles, and it’s important for investors to do their due diligence. In today’s volatile environment, high-quality bonds help investors play defense, but we also see some opportunities in select lower-rated investment-grade credit.
Although it may seem counterintuitive, we believe that select banks and technology companies may help buffer market volatility.
In the US, senior bank bonds currently have attractive valuations and strong starting fundamentals, and in our view, they may benefit from an improving technical backdrop. The discount for senior bank bonds versus non-financials is at the widest level we’ve seen in more than a decade. At the same time, bank supply continues to underwhelm, with new issues from financials down 39% versus this time last year.
European banks trade at a discount to their US peers and may be sheltered from some of the recent issues facing US regional banks. Globally, investors might also consider covered bonds—a high-quality segment that can serve as a buffer within the more cyclical banking industry.
Despite their reputation as high-risk plays in a volatile sector, technology firms with strong business models and resilient income streams can provide a defensive layer to a portfolio. Here we see yield potential in attractively priced, longer-dated securities without the need to sacrifice credit quality. We also see opportunities in select BBB-rated issuers, where we believe that spreads more than compensate for potential risks given the issuers’ strong cash-flow profiles and commitment to investment-grade ratings.
The coming months are likely to offer another dose of mixed economic news. It can be difficult to make sense of it all and allocate assets accordingly. But given sound corporate fundamentals, compelling valuations and strong asset flows, we believe that investment-grade corporates deserve a closer look.