Riskier Corporate Debt Beats Blue Chip Bonds as Fed Pulls Back Stimulus
Riskier Corporate Debt Beats Blue Chip Bonds as Fed Pulls Back Stimulus
(Bloomberg) -- For an investor, this has been a great year to take credit risk, and it looks like more of the same in 2022, even as the Federal Reserve dials down stimulus that triggered a borrowing bonanza.
Blue-chip corporate bonds face the longest losing streak in 40 years because of their high duration, or sensitivity to rate increases. Junk-rated debt is meanwhile supported by a recovering U.S. economy, robust balance sheets, the global hunt for yield and record low default rates.
Returns will be harder to come by across the board in 2022 amid lofty valuations that make corporate debt particularly susceptible to any sudden economic slump.
“Spreads are very tight,” said Kamakshya Trivedi, co-head of global FX and interest rates at Goldman Sachs Group Inc. “If things go badly, like if for whatever reason the economic recovery takes a sharper move lower, or you get a big increase in interest rates, returns in that asset class are going to be quite limited.”
With three rate hikes forecast for 2022, companies of all types are expected to slow the pace of debt sales after a record two-year splurge, providing a technical boost. Solid fundamentals, including high cash balances and low debt compared to earnings, are emboldening investors.
High-Grade Low
U.S. investment-grade bonds are down more than 1.3% on a total return basis this year, and many expect more pain in 2022, mostly from rates. The Bloomberg high-grade index hasn’t recorded back-to-back annual losses since 1980.
| Bank | Year-End ‘22 Spread | Total Return | Supply |
|---|---|---|---|
| Bank of America | 95 bps-110 bps (ICE Index) | Flat | $1.3t-$1.4t |
| Barclays | 95 bps-100 bps (Bloomberg Index) | 0%-0.5% | $1.17t |
| Citigroup | 100 bps (FTSE Russell Index) | -3.5% | $1.46t |
| Deutsche Bank | 105 bps (ICE) | -1.1% | $1.4t |
| JPMorgan | 100 bps (JULI Index) | -0.8% | $1.35t |
| Morgan Stanley | 100 bps (Bloomberg) | -1.8% | $1.55t-$1.75t |
Spreads are seen holding a tight range as lower issuance and continued strong demand from investors around the world counter the risks of a pandemic flare up that dents economic growth, as well as the impact of higher rates.
“Technicals will probably overwhelm any kind of volatility,” said Todd Mahoney, head of U.S. debt capital markets at UBS Group AG. “We expect consistent inflows, supply down, and a pretty good year for redemptions. When you put all those things together, it should be enough to hold spreads.”
Issuance is expected to be as much as 10% less than this year’s $1.4 trillion, which was the second highest ever. Strong earnings and elevated levels of cash on balance sheets should add support, though some companies may still look to boost debt, risking credit-rating downgrades.
“Even if the economy were to slow down with the Fed hiking progressively, we think corporations are in much better shape to handle it,” said Matt Brill, head of North America investment-grade at $1.6 trillion asset manager Invesco Ltd.
Junk Shines
U.S. high-yield is among this year’s top performers in global fixed income and forecasters expect similar gains for 2022. Issuance will likely be robust by historical standards, but fall short of this year’s record setting $460 billion, providing support to prices.
| Bank | Total Return | Supply |
|---|---|---|
| Bank of America | 4%-5% | $425b |
| Barclays | 3%-4% | $400b-$420b |
| Citigroup | 1.5% | $400b |
| Deutsche Bank | 1.5% | $400b |
| Goldman Sachs | N.A. | $325b |
| JPMorgan | 4.4% | $425b |
| Morgan Stanley | -0.1% | $405b-$435b |
The negative impact of rising rates -- which will mostly affect the higher-quality bonds -- is expected to be offset by a rebounding U.S. economy and robust balance sheets. And the default rate is set to end the year just below the record low set in 2007, according to Fitch Ratings.
In addition, about $70 billion of junk debt is expected to be promoted to investment grade in the next 12 months, according to Bank of America strategist Yuri Seliger.
Read More: Junk Issuance Torrent to Moderate in 2022, Underpinning Returns
Loan Reflation Boost
Given their floating-rate nature, leveraged loans stand to benefit from investors seeking hedges against inflation. Higher rates will meanwhile make borrowing more expensive, leading to a slight decline in issuance.
| Bank | Total Return | Supply |
|---|---|---|
| Barclays | 3.5%-4.5% | $480b-$500b |
| Citigroup | 3% | $600b |
| Deutsche Bank | 1.8% | N.A. |
| JPMorgan | N.A. | $350b net |
| Morgan Stanley | 2% | $570b-$600b |
Transition to the Secured Overnight Financing Rate from the London Interbank Offered Rate starting in January could create volatility. Collateralized loan obligations, which repackage leveraged loans, are still expected to provide robust demand.
“A rising rate environment and above trend growth is typically a good environment for the loan market,” said Frank Ossino, bank loan sector head at Newfleet Asset Management. “We want to be risk on but recognize current valuations will make 2022 a credit picker’s market.”
Structured Yield Grab
Rising inflation in the U.S. could end up being much better for consumers than for companies, so investors should be rotating out of corporate bonds and into asset-backed securities and other securitized debt, according to strategists at Goldman Sachs Group Inc.
Supply-chain disruptions are likely to limit corporate profits next year, which could hurt company debt, while pushing home and car prices higher, helping securities backed by those assets. Meanwhile wage inflation pressure that many companies are seeing will weigh on corporate profit while helping consumers, wrote Goldman Sachs strategists led by Marty Young and Lotfi Karoui.
Also, valuations look better in securitized bonds than for corporate bonds on a historical basis, the strategists wrote. For example investment-grade corporate bond spreads are in their fifth percentile for their tightness over the last five years, while AAA CLOs are at their 14th percentile.
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