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This is an audio transcript of a Talking Heads podcast episode. Consider the “cushion” of US investment grade bonds
daniel morris: Hello. Welcome to the BNP Paribas Asset Management Talking Heads Podcast. Each week, Talking Heads delivers deep insight and analysis on the topics that really matter to investors. This time, we will discuss the US investment grade market. I’m Daniel Morris, Chief Market Strategist. And today I’m joined by U.S. Investment Grade Portfolio Manager Irriex de James. Welcome, Yrieix, and thank you for joining us.
iriex de james: Thank you, Daniel. It’s great to be here.
DM: Considering the US investment grade (IG) market, which has more or less completed its earnings season, it seems to have performed quite well. The surprise was very positive and above average. Corporate performance has exceeded expectations, and we believe the outlook is generally quite optimistic. I think you’ll talk about how investment grade bond spreads reflect that perspective. But let’s start with an overview of what has happened so far in the US investment grade market in 2024 and what to expect in the coming quarters.
YDJ: The U.S. economy remains exceptional, with strong GDP growth and a slowing but resilient labor market. In response, the U.S. Federal Reserve (Fed) announced that it would be lower than the market had originally expected in March, due to concerns that easing monetary policy could upset this trend and cause inflation to rise again. This led to the postponement of the second interest rate cut. That was confirmed by the latest Consumer Price Index (CPI) results.
On the earnings front, U.S. companies have had mixed results, but overall they remain healthy, with 80% beating consensus estimates. The news from New York Community Bank has reignited concerns about commercial real estate and its impact on banks, but overall, the backdrop so far has been fairly favorable for the asset class. ing.
U.S. investment-grade credit spreads have recorded a return of 0.56% relative to U.S. Treasuries since the beginning of the year, and continued strong performance from November to December 2023 on a total return basis. Including the movement in US interest rates, the performance declines by 1.57%.
Looking ahead, we expect the U.S. IG market to remain resilient throughout this year as yields remain high, but given the strength of the U.S. economy and the health of corporate balance sheets, fundamentals are also expected to remain strong. We believe that a strong market will respond to that. Demand from the investment community.
Some risks remain, particularly election and geopolitical risks around the world. However, we view investment-grade regions in the United States as relatively isolated compared to other regions in the developed world. We are also aware of our current situation from a valuation perspective, and believe that in an environment where yields are low, we will see an increase in mergers and acquisitions and shareholder-friendly businesses, making it cheaper to fund such businesses. We are also aware of the risks.
This typically means some pressure on bondholders, as companies have less capital available to service debt. However, in our view, corporate balance sheets are stronger than they were in 2019, and corporate management teams are generally more disciplined with respect to capital. This should help prevent a wave of large-scale credit downgrades.
Credit spreads as a percentage of total yields are at an all-time low. This suggests that investors are not adequately compensated for taking on the credit risk of US IG companies over US Treasuries. In our view, this reflects strong sentiment towards the asset class on the back of rising yields. That doesn’t necessarily mean credit spreads will widen significantly going forward and supply-side performance will suffer.
January was very strong and February is set to be even more impressive. This is typically a headwind for credit spreads, as new deals tend to be cheaper than existing bonds, and investors sell existing bonds to fund the purchase of new bonds. Both of these factors lead to widening credit spreads and negative performance.
This time, however, supply has been met by even stronger demand, offsetting the weaknesses I mentioned earlier. We expect this year’s supply to end up slightly below last year’s levels, driven primarily by corporates, but financial institutions, especially banks, will first refinance maturing debt before regulators This is likely to be flat year-on-year as the company faces increasing pressure to increase capital from China.
Strong demand for U.S. investment-grade stocks is evidenced by healthy inflows into the asset class so far this year. We believe U.S. investment grade stocks will be an attractive asset class in 2024 due to a healthy fundamental environment, strong demand, and rising yields that provide some cushion.
DM：On the other hand, a certain amount of supply is expected for corporate bonds and investment grade bonds, but this is expected to be offset by good demand. What is driving demand for this asset class and how do you expect it to evolve in 2024?
YDJ: Historically, demand for IG credits in the United States has come primarily from domestic insurance companies. This includes not only life and non-life insurance companies, but also pension funds and foreign investors, particularly in Asia. The latter has expanded the most rapidly over the past decade, while life insurance companies have seen the biggest decline in demand from mutual funds.
Therefore, the retail part of the market is quite small compared to the rest, around 18% to 20% of the total demand. However, after a mixed 2023, it increased throughout the year as rising yields made this asset class attractive again. From a demand perspective, the beginning of 2024 is supported by strong inflows into the asset class. We expect demand to remain strong throughout the year, even in an environment of slower growth. [interest] Interest rates will fall and cash will become less attractive than credit. This should help support credit spreads.
Demand for long-term bonds is particularly strong not only because their supply is low and their scarcity increases their value, but also because of their high yields and strong demand from so-called yield-oriented investors looking to secure attractive long-term bonds. This is because the incentives overlap. income.
This situation is likely to continue for as long as it lasts. [interest] Interest rates remain high, but should rise as monetary policy eases. That would favor short-term bonds with maturities closer to 10 years.
On the other hand, investors are focusing more on credit spreads than on yields and are starting to show some nervousness given the exaggerated valuations. However, it is abundantly clear that rising interest rates involve volatility, and spreads are unlikely to widen significantly absent a major external shock.
DM: There are many different sectors within investment grade. As we look at how the U.S. economy is developing, you mentioned that commercial real estate is an area of concern. There are also concerns about consumer demand, especially as excess savings that people accumulated with government support during the pandemic are depleted. Considering all this, what part of the US investment grade market do you find most interesting?
YDJ: We expect this asset class to remain resilient. Valuation is important, but we like sectors that have performed well through cycles, have strengthened balance sheets, and are in a better position now than they were a few years ago. This includes financial institutions such as banks, particularly the largest banks in the United States and Europe, but also large regional banks in the United States.
I also like real estate investment trusts. [REITs], it still looks cheap and you can choose the assets you like the most. Given that many issuers in this space operate in a variety of non-financial markets, we believe that the highest rated parts of the corporate segment are less attractive from a credit perspective.
This reflects investors’ increasing quality of bonds, particularly those with longer durations, into 2023. However, a large portion of the market still favors the defensive end as it could provide some downside protection in a scenario where US investment grade stocks are under pressure.
More than that, we love BBB [rated] Corporates, particularly those in sectors that have shown discipline in reducing debt and increasing cash flow, are still significantly undervalued compared to higher-rated issuers. These companies should outperform in a slowing economy, unless the U.S. falls into a full-blown recession.
They also tend to favor companies with deeper ties to the United States. Given the strength of the economy, we believe it makes sense to increase the revenue portion of our revenue, rather than relying any more on rising market prices, and we have recently taken steps to optimize our revenue. We favor bonds with higher coupons.
DM: Mr. Yrieix, thank you very much for joining us.
YDJ: I was very happy.
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