The Case for Corporate Credit

28 July 2023

3 min read

Will Smith, CFA| Director—US High Yield

Tiffanie Wong, CFA| Director—Fixed Income Responsible Investing Portfolio Management; Director—Global & US Investment-Grade Credit

Solid fundamentals, decent valuations and attractive income potential make a case for continued exposure to corporate credit even in an uncertain economic environment.

Investors often reduce allocations to corporate bonds—particularly those on the lower rungs of the ratings ladder—when the economic outlook gets cloudy. And there have been plenty of clouds on the US and eurozone horizons, including inflation, rapidly rising interest rates, and lingering concerns about midsize and regional banks.

That doesn’t mean investors should be shying away from corporate credit, in our view. Slower economic growth is unlikely to result in wholesale deterioration of credit conditions or, in the case of high-yield bonds, a wave of downgrades or defaults. Here’s why:

Reason 1: Starting Fundamentals Are Strong

Top line growth and earnings among corporate borrowers have lost some momentum—not too surprising given the rapid tightening of financial conditions over the last year. But context matters. Corporate fundamentals are usually weak on the brink of a slowdown. Today, both investment-grade and high-yield companies enter this period from a position of strength.

Start with investment-grade issuers: revenue growth and profit margins are coming off their highest levels in more than a decade, and companies are managing their balance sheets conservatively, with both operating and sales costs declining as a percentage of revenue. That’s helped first-quarter earnings beats outnumber misses. Cyclical industries such as autos and capital goods that would be expected to struggle in a slow growth environment have done well.

Companies also did an excellent job of locking in lower yields in recent years; it will take time for the impact of higher rates to flow through to interest expenses. Leverage and coverage ratios and free cash flow among investment-grade issuers have all improved.

On the high-yield side, many issuers began managing balance sheets and liquidity more conservatively during the pandemic, helping profitability recover. The weakest issuers, on the other hand, were weeded out when high-yield defaults peaked at 6.3% in October 2020. That was less than three years ago. Since then, there simply hasn’t been enough time for the survivors to develop unhealthy financial habits.

What’s more, some defaulted bonds were replaced by those from the lowest-rated investment-grade bonds that fell into the high-yield market. These “fallen angels” helped to raise overall index credit quality. Today, BB-rated bonds—the highest high-yield rating—make up 49% of the market, compared to 43% on average over the past 20 years.

High-yield companies also extended maturity runways following the pandemic, a key component of the de-risking playbook. But many borrowers have opted not to refinance since the Federal Reserve began raising rates in 2022, as doing so would have involved exchanging a current average coupon rate of 5.8% with one closer to the market’s yield to worst of 8.5%. The result: the weighted average maturity of the broader market dropped to 5.1 years from a long-term average of 6.6 years. Over the next 12 to 18 months, the amount of debt set to mature appears manageable; we expect the US default rate to remain in a low range of 4% to 5% over that time. Beyond that, however, refinancing needs will rise. How well the economy fares over the medium term will determine how difficult refinancing will be—and underscores the importance of a selective investment strategy.

Reason 2: Valuations Are Reasonable

Credit spreads—the difference between corporate bond yields and government bond yields—are hovering near their long-term averages for both investment-grade and high-yield debt (Display), while average prices for US dollar- and euro-denominated bonds are near lows last seen during the Global Financial Crisis.

Global Corporate Bond Spreads Near Long-Term Averages

Line graphs show that investment-grade and high-yield corporate spreads are near their average levels dating back to 2002.

Past performance and current analysis do not guarantee future results.
*GFC: Global Financial Crisis
As of June 30, 2023
Source: Barclays, Bloomberg and AllianceBernstein (AB)

Today’s low prices are largely a function of the rise in government bond yields since early 2022; typically, it would take significant spread widening to push prices to these levels. But lower prices can provide cushion if future market volatility does widen spreads. That’s what happened in March when the failures of several midsized US banks rattled markets.

In the US, rising Treasury yields have helped drive investment-grade corporate yields higher as well. That comes with a bonus: historically, high yields have been good predictors of forward returns.

Among US investment-grade securities, senior bank bonds have particularly attractive valuations and strong starting fundamentals and may benefit from an improving technical backdrop. At the same time, bank supply continues to underwhelm, with new issues from financials down 31% on the year through June.

European banks trade at a discount to their US peers and may be sheltered from some of the challenges 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.

Reason 3: High Yields Are Truly High

If spreads widen, however, today’s elevated yields—particularly in the lower-rated high-yield market—should provide ample cushion for investors. High-yield bonds supply an income stream that few other assets can match, and over a longer time horizon, investors are likely to convert those yields to return.

Yields on high-yield debt today are higher than they’ve been in quite some time and starting yield has been a strong proxy for a bond’s likely return over the ensuing five years. The yield-to-worst for the broad US high-yield market stands at 8.5% (Display).

Yield to Worst Has Historically Been a Strong Predictor of Future Returns

Bloomberg US Corporate High-Yield Index: Yield to Worst and Five-Year Forward Annualized Return (Percent)

Yield to worst was in line with forward five-year return in random periods over past two decades. YTW as of April 2023: 8.5%.

Past performance and current analysis do not guarantee future results.
Through July 7, 2023
Source: Bloomberg and AB

This relationship between starting yield and five-year forward return held steady even during the Global Financial Crisis, one of the most stressful periods of economic and market turmoil on record. If an investor had bought high yield in May 2007 at a yield to worst of 7.5% and held onto that investment for the next five years—riding out a 36% drawdown in the high-yield market—that investor would have earned 7.6% in total return on an annualized basis.

Even so, we recommend caution when it comes to CCC-rated debt, the lowest-rated corporate bonds, which are most vulnerable in an economic downturn. Investors may also want to be choosy when it comes to high-yield bank loans, which we believe are more vulnerable in this cycle due to the impact of significantly higher borrowing costs.

But the global corporate bond market is a diverse and resilient one. Even in the late stages of a credit cycle, it can offer an attractive mix of income, stability, and potential return.

The views expressed herein do not constitute research, investment advice or trade recommendations, and do not necessarily represent the views of all AB portfolio-management teams and are subject to change over time.

About the Authors

Will Smith, CFA

Will Smith is a Senior Vice President and Director of US High Yield Credit. He is also a member of the High Income, Global High Yield, Limited Duration High Income, Short Duration High Yield and European High Yield portfolio-management teams. Smith designed and is one of the lead portfolio managers for AB’s Multi-Sector Credit Strategy, which invests across investment-grade and high-yield credit sectors globally. He leads the monthly High Yield portfolio-construction meeting, and is a member of the Credit Research Review Committee, which determines investment policy for the firm’s credit-related portfolios. Smith has authored several papers and blogs on high-yield investing, including one on the importance of using a probability-based framework to build better portfolios. He joined AB in 2012, and spent 2014 in London as part of the European High Yield portfolio-management team. Smith started his career with UBS Investment Bank, working as an analyst with the Credit Risk team and then later on the Fixed Income sales and trading desk. He holds a BA in economics from Boston College and is a CFA charterholder. Location: Nashville

Tiffanie Wong, CFA

Tiffanie Wong is a Senior Vice President and Director of Fixed Income Responsible Investing Portfolio Management. In this role, she is part of the leadership team that develops responsible investment strategy across AB's Fixed Income business, particularly related to integrating environmental, social and governance considerations throughout the team's portfolio construction processes and overseeing management of several of the team's sustainable strategies. Wong also serves as Director of Global & US Investment-Grade Credit, responsible for the management and strategy implementation of the firm's Global & US Investment-Grade Credit portfolios, including total-return and income-oriented credit strategies for institutional and retail clients. She has worked closely with AB's Quantitative Research team to leverage the firm's technology innovations within fixed-income trading and research to apply a more systematic approach to AB's credit investing. Prior to joining AB's Fixed Income portfolio-management team, Wong served as an associate portfolio manager on the Credit team, focusing on various strategies for the Global and US Credit portfolios—including total return, buy and hold, and liability matching. Before joining AB in 2012, she was a fixed-income portfolio analyst and trader at Segall Bryant & Hamill and a fixed-income portfolio associate at Wells Capital Management. Wong holds a BA in economics with a minor in business institutions from Northwestern University and is a CFA charterholder. Location: New York

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