Three market scenarios: how would credit perform?

There are many situations that could influence corporate bond investment performance in the next 12 months. Making a single prediction about where corporate debt markets are going is fraught with difficulty. The best way to look at this is to consider how corporate bonds might behave under three different scenarios. From this, we can then look at the implications for investors.

Let’s start with the economic backdrop and set up three possible combinations of inflation, interest rates and growth which—with a nod to Sergio Leone—we’ll call The Good, The Bad and the Ugly. Amazingly, the market priced in all three scenarios during the first few months of 2023.

1. The Good – soft landing.

In this scenario, economic growth slows, but to a sustainable rate without experiencing recession or a financial crisis, as well as managing inflation. Inflation has been tamed without too much damage to the economy. There’s no need for further interest rate rises and business conditions are healthy. This was the case at the beginning of 2023. Investment markets rose, as inflation expectations eased, and recession fears receded.

2. The Bad – hard landing.

In this scenario, “the cure risks killing the patient.” A hard landing happens - a sharp fall in economic activity. You typically see rising unemployment, falling asset prices, pressure on banks, strained government finances and a general sense of economic instability. While central bank interest rate hikes get inflation under control, something in the economy breaks in this process. This scenario happened in March, with banks failing, starting with Silicon Valley Bank of the US collapsing. These bank failures happened because central bank tightening caused market yields to rise rapidly and eventually led to depositors withdrawing money en masse to take advantage of better returns elsewhere.

3. The Ugly – interest rates go back up.

In this “no landing”—or perhaps more accurately “abortive landing”—scenario, inflation remains sticky and there’s a reacceleration of interest rate hikes. Corporate debt markets were pricing in an extreme version of the Ugly scenario for much of 2022 amid fears that quantitative tightening by central banks would jeopardise growth. We saw a milder version of this in February this year as signs emerged that inflation might be higher for longer, with the possibility that central banks might need to toughen their stance and potentially forcing a recession.

So, in the first three months of 2023 we saw a progression from Good, to Ugly, to Bad and then tentatively to Good again as it appeared that monetary and fiscal measures had successfully stemmed a wider banking crisis. It’s safe to assume we’ll see more oscillations in the next 12 months, so let’s put some numbers on what this might mean for asset allocation.

The table below looks at how the three interest rate and growth scenarios might play out on government bond yields and credit spreads (the yield premium for holding corporate bonds). It then shows the impact on bond prices.

We assume that the corporate bond investment has been bought at an initial yield of 5.5% and then we adjust for capital gains or losses from price changes. So the total return reflects returns from interest income plus any price appreciation or loss.

Note that this is not a real-world prediction or a recommendation, but a simplified illustration to give an idea of direction and scale of change.

The first thing to note from the table is how resilient credit can be as an investment. In the Ugly scenario, when rising government bond yields and widening credit spreads knock 6.25% off credit prices, the loss is still less than 1%. If investors can lock in an attractive yield at the offset, this can help insulate them from market falls.

The 5.5% shown here is  the average yield of corporate debt from bonds ranging widely in risk (technically referred to as the single A to single B rated segment of the global Bloomberg Barclays Multiverse, in US dollar terms, at the end of March 2023).

But active security selection may be able to improve on broad index outcomes by selecting bonds with more attractive yields.

Active bond selection allows investors to select the best instruments for the job in different environments. Credit investors face two main risks: interest rate exposure and credit exposure. The goal is to focus on the types of credit that can help capture the upside and reduce the downside risks. How might this work in practice?

1. The Good (interest rate risk falling, credit risk falling). If you expect a soft landing, where rates are falling and business conditions are favourable, you’ll want to look for opportunities to add interest rate exposure with longer maturities and add credit exposure via high yield.

2. The Bad (interest rate risk falling, credit risk rising). If you think rates have peaked but the economy is in trouble, you’ll want more interest rate exposure and less credit exposure, in other words, longer maturity bonds and more investment grade corporate debt. In this scenario default rates tend to rise, so this is where bottom-up research is most important. In fixed income investing, avoiding the blow-ups is more important than picking winners, and company-specific analysis is the best risk management tool to help do that.

3. The Ugly (interest rate risk rising, credit risk rising). If you expect a scenario where interest rates bounce back up, the main priority is to reduce interest rate exposure, with short-dated or floating-rate credit. High yield corporate bonds are less interest rate sensitive because of their wider spreads (higher yield premium over government bonds), but it depends how ugly you expect the economic impact of the interest rate rises to be. One way to go would be to stay near the “crossover” section of the ratings spectrum where low investment grade meets strong high yield. But if you expect stagflation (low economic growth with high and persistent inflation), the more defensive route would be to focus on investment grade company debt where the business has strong pricing power.

There are other possible scenarios, so these examples are not exhaustive, but we think these three are the most probable in the current environment.

Investors’ confidence in the value of the credit toolkit, and fixed income in general, took a hit last year as bonds failed to play their traditional role as a risk diversifier. But consider two data points: (1) this was the first year since 1969 that we’ve seen both bonds and equities fall and (2) the pace of US Federal Reserve rate rises was the fastest in 40 years. When markets are more worried about inflation than growth, bonds will struggle. But when growth concerns eclipse inflation concerns, that’s when the normal relationship is restored. We expect credit to come back as a good potential hedge for equities because of its versatile profile across different scenarios.