Weakening economic fundamentals shouldn’t scare away corporate bond investors in 2024—provided they keep a close eye on credit quality.
Investors tend to worry about corporate bonds late in the credit cycle. That’s because prolonged monetary tightening and high interest rates eventually curb growth, increase costs and raise the risk of default. But this time, things look more encouraging. Here’s why.
Fundamentals Have Weakened but Remain Solid
Fundamental metrics are showing signs of deterioration to start the year, particularly among the lowest-rated credits. Revenue and earnings growth, EBITDA margins, and interest coverage ratios are all coming under pressure (Display).
Fortunately, these same metrics are coming off historic highs, thanks to a pandemic-fueled default wave that vanquished weaker players and prompted survivors to be more fiscally prudent. In fact, revenue growth and EBITDA margins aren’t far removed from their highest levels in more than a decade. And interest coverage ratios are strong enough to stay above average in both investment grade and high yield, even if issuers refinance at today’s elevated rates or earnings decline.
A deeper dive into fundamentals uncovers opportunities, too: among nonfinancial firms, EBITDA margins for BBB-rated securities are similar to those of A-rated issues, offering investors in BBBs a similar earnings profile at higher yields.
Sound balance sheets mean corporate issuers can withstand increased pressure as growth and demand slow. This is reflected in corporate credit ratings, which have improved across the entire investment-grade universe, with upgrades outpacing downgrades by a wide margin (Display).
Further, companies have alleviated financial pressure by extending their maturity runways. Only 10% of the high-yield market will mature by the end of 2025, and most of this debt will be of higher quality. Gradual and extended maturities slow the impact of higher yields on companies, while higher-quality issuers should have little trouble refinancing (Display).
As a result, we expect a moderate default rate for the next 12 to 18 months—around 4% to 5%—rather than a tsunami of defaults and downgrades. That said, we think investors should favor higher-quality credits, remain selective and pay attention to liquidity. CCC-rated debt—particularly credits in cyclical industries—are most vulnerable to defaults and economic downdrafts. Debt rated B or higher may be a better choice in today’s environment.
Yields and Spreads Remain Elevated
Yields enter the new year still elevated by historical measures (Display).
How long they’ll remain at these lofty levels depends on how successful central banks are at warding off inflation. Owing in part to lower economic growth rates across the eurozone, the European Central Bank can cut rates earlier than its peers, while disinflation may have further to run before the Bank of England eases monetary policy. The US Federal Reserve has signaled its intention to cut rates three times in 2024, but for the time being, the fed funds rate is at its highest level in more than two decades.
High-yield investors are among the best positioned to benefit from today’s elevated yields. A high-yield bond’s starting yield to worst has historically been a strong predictor of return over the next three to five years. Today, the yield to worst for the global high-yield market is 7.6%.
Within investment grade, European credit spreads—the difference between corporate bond yields and government bond yields—narrowed by more than 50 basis points (bps) over the past year but are still 25 bps above their historical norms. US investment-grade credit spreads currently hover near their long-term averages. Given large flows into money market funds in recent years, when investors become more comfortable with more interest rate–sensitive duration securities, we would expect demand for investment-grade credit to increase substantially.
Intermediate-Term Credits Offer Value
But averages can be deceptive. A closer look reveals that intermediate-term corporates are a much more compelling opportunity than long-term ones. Why? Yield-focused investors such as insurance companies have been buying long-dated investment-grade securities to match their long-dated liabilities, driving long yields down relative to the rest of the market. As a result, we believe longer-term bonds don’t compensate investors for the added term risk.
This phenomenon is global: US, UK and eurozone bonds longer than 10 years all look expensive relative to intermediate-term credit. For this reason, we believe that some of the best value can be found in the belly of the yield curve within investment grade.
Lastly, technical conditions have also improved since the pandemic, aided in part by increased demand, positive ratings changes and limited issuance. In the US, investment-grade bonds saw monthly inflows through the third quarter, underscoring investor confidence, which in our view should help support valuations in 2024. In Europe, technical factors have been more mixed.
Given the uncertain economic outlook in 2024 and fraying fundamentals, investors could be excused for eyeing the corporate credit markets with caution. But today’s high yields won’t last forever, and with valuations still reasonable, the start of the new year could present a unique opportunity for prudent fixed-income investors.
- Tiffanie Wong
- Director—US Investment Grade Credit
- Will Smith, CFA
- Director—US High Yield
- Robert Hopper
- Director—High Yield and Emerging Market Corporate Credit Research