2023 Corporate Bond Outlook: It Is Ok to Be Long

Summary

• Corporate bonds spreads will widen significantly if, as we anticipate, persistent inflation leads to higher rates and a recession later this year.
• But US companies are going into this likely scenario with exceptionally strong balance sheets.
• The surprise for many will be that default rates rise less than in previous recessions, and how quickly credit spreads recover.

Market Implications

• For investors who can live with some volatility we recommend a marketweight position in investment grade and high yield corporate bonds.
• Investors can gain exposure to corporate bonds by holding ETFs – LQD for investment grade and HYG or JNK for high yield.

Introduction

As we discussed in our US equity market outlook, we are not constructive on either the economic outlook in 2023 or equities. In short, we expect inflation will prove to be more persistent than equity markets (and perhaps the Fed) now think, leading to more rate hikes later this year and the prospect of a recession.

Such a scenario should also be negative for investment grade and high yield bonds. History strongly suggests credit spreads will gap out in anticipation of rising default rates (Charts 1 and 2).

Yet we are constructive on corporate credit because many companies have taken advantage of the low interest environment of recent years to significantly improve their balance sheets. In a recession scenario, credit spreads will gap out. But the surprise will be how quickly they recover if, as we believe, default rates rise only modestly.

Companies Are Well Positioned to Weather a Recession

Charts 3-8 summarise credit metrics for S&P 500 non-financials over the past decade. Note the following points:

• Over the past three years, net debt outstanding has been flat (Chart 4).
• Companies refinanced existing debt to extend maturities (Chart 4), reduce the average cost of debt from 3.5% to 2.5% (Chart 5), and boost interest coverage ratios from 6 to 7.5 (Chart 6).
• Leverage ratios, as measured by debt/equity and debt/EBITDA, are at long-term normal levels (Charts 7 and 8).

In short, the so-called ‘distance to default’ has lengthened. Especially significant is the lower interest cost and higher interest coverage ratio. Many weak or outright zombie companies can carry on for some time; the hammer falls when they cannot roll over maturing debt.

Energy Sector Risk Is Much Diminished

Another reason that default rates may be lower than in previous cycles is a far more conservative energy sector. In the past, oil and gas companies would have taken advantage of high oil prices to lever up and pursue new exploration and development projects, then face a reckoning when prices collapsed. That was behind the default wave in 2015.

However, as we discuss in our equity outlook, oil and gas companies are now focusing on existing operations and prioritizing returning cash to investors.

How to Invest in Corporate Bonds

We suggest holding the investment grade sector via the LQD ETF and high yield via HYG or JNK ETFs and riding out possible spread volatility later this year.

We note that the corporate bonds in the ETFs are exposed to both credit and rate risk. Investors who want to avoid rate risk can short Treasury ETFs. A good alternative for the longer duration LQD is IEEF (7-10-year Treasuries). For the intermediate duration high yield sector, we suggest VGIT (intermediate maturity Treasuries).

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)