The range of possible economic outcomes is widening, arguing for building higher quality ballast into portfolios. One way we advocate doing this: exposure to investment grade bonds.
Investment grade (IG) bonds typically outperform their high yield counterparts when uncertainty rises, given their higher quality and lower default risks. The chart below shows this hasn’t been the case lately thanks largely to issuance trends.
The bars on the left depict the recent under-performance of IG. Yield spreads have widened versus Treasuries, putting downward pressure on prices. The move in the high yield market has been much more muted. The bars on the right show why. Actual, and anticipated, IG issuance has rapidly escalated amid a surge in mergers and acquisitions (M&A) activity, particularly in the media sector (overall IG issuance is still down just over 1% due to large repatriated cash balances providing less incentive to issue debt). Yet high yield issuance has slumped. The shrinking high yield market is not part of the M&A boom, and many high yield firms are issuing via loans rather than bonds.
An alternative to “TINA”
IG issuers’ greater global exposure versus high yield issuers may also be playing a role in these performance trends as trade tensions rise. The trends have been exacerbated by a changing interest rate environment: IG issuers are wanting more debt funding in a more demanding environment. Rising short-term rates have increased competition for capital, posing a sea change for U.S. dollar-based investors. There is less need to stretch for yield when dollar-based investors can get above-inflation returns in short-term “risk-free” debt. Case in point: Hefty outflows from emerging market debt funds contrasted with U.S. money fund assets up by $203 billion year over year, according to the Investment Company Institute. Investors now have an option other than “TINA” (there is no alternative).
Higher short-term rates may be here to stay, but we expect quality exposures to reassert their typical resilient nature following the recent surge in actual, and expected, IG issuance. We view the recent uptick as a temporary supply shock. It partly reflects a shift in issuance expectations after a mega media merger was given the green light. Yet for IG under-performance to persist, we would need to see a sustained rise in issuance expectations. We view this scenario as unlikely as the recent mega-merger news was a one-time event. Against this backdrop, investment grade valuations have become more attractive relative to those of high yield. Yields for short-maturity investment grade corporates are now well above the level of U.S. inflation. We see these assets again playing their traditional portfolio role—principal preservation, especially in an increasingly uncertain macro environment.
Our base case is that the post-crisis cycle still has room to run. Yet uncertainty around the growth outlook has widened, with the U.S. stimulus’ boost to activity on one side–and trade war risks on the other. This greater uncertainty−along with rising interest rates−has contributed to tightening financial conditions and argues for higher-quality ballast in portfolios.