The dynamics of supply and demand continue to favor investment-grade U.S. bonds.
After a blockbuster year for holders of US investment-grade (IG) credit (corporate bonds), investors are left staring at tighter spreads and lower all-in yields, scratching their heads wondering where the returns will come from in 2020. The Bloomberg Barclays IG Credit Index returned 13.8% in 2019 and now yields 130 bps less than just a year ago (4.09% in 2019 versus current yield of 2.79%). It seems natural, then, to consider rotating out of the asset class as surely there is no meat left on the bone, right? Many investors have done just that and have reduced their allocations to IG credit. However, once investors take a closer look at the underlying corporate fundamentals and the positive technicals, we think they may want to consider holding on for what is likely to be another year of the continued hunt for yield.
While fundamentals in the corporate credit space have remained strong over the past year, the larger shift has taken place on the technical side of the market as central banks continue to inject liquidity into markets in an attempt to raise inflation expectations. The Fed's balance sheet alone has increased by over $400 billion in just the past six months, a liquidity boost that has undoubtedly been a steady tailwind for IG credit. At the same time, global central banks have continued to lower interest rates with a combined 62 rate cuts over the past 12 months. This has increased the total amount of negative-yielding debt around the world to well over $13 trillion-a powerful dynamic that forces investors to look elsewhere for income. So while the 2.79% yield on the IG Credit Index may seem paltry to many of us here in the US, the reality is that IG credit still offers a very good risk/reward proposition when placed into the context of global yields. In our view, the sizeable inflows already seen in 2020 confirm that global demand continues to be very strong for the asset class.
There is more than $1 trillion of supply expected in IG credit this year. That surely will be enough to satisfy the global demand, won't it? Investors need to think again. While gross supply in IG credit is forecast to be down slightly this year, net supply will be almost 40% lower than it was in 2019, which will be the lowest number in a decade, providing an opportunity for yet another positive technical tailwind to the IG market. We believe this is due to the large number of maturities coming due this year, which investors will likely pour right back into IG credit given the strong fundamentals and lack of viable investment alternatives.
Western Asset's Credit Team employs a bottom-up, fundamentals-driven investment philosophy. As such, we will always start with analyzing the fundamentals of any investment thesis. In years such as this when the fundamentals continue to be strong and stable, investors would be well served to take a deeper look into the technicals before giving up on investments in US IG credit.
The Bloomberg Barclays U.S. Credit Index is a broad-based index composed of government and corporate debt issues that are investment grade (rated Baa/BBB or higher).
A spread is the difference in yield between two different types of fixed income securities with similar maturities.
One basis point (bps) equals one one-hundredth of one percentage point.
Investment-grade bonds are those rated Aaa, Aa, A and Baa by Moody’s Investors Service and AAA, AA, A and BBB by Standard & Poor’s Ratings Service, or that have an equivalent rating by a nationally recognized statistical rating organization or are determined by the manager to be of equivalent quality.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.