Can credit keep calm and carry on

With cracks starting to show in the US economy, many are wondering whether tight corporate bond spreads leave investors vulnerable. But with corporate balance sheets holding firm and yields on higher quality bonds looking attractive, staying invested in credit should continue to reward investors.  

Ever since the Federal Reserve (Fed) hiked interest rates to a peak of 5.5% in July 2023, market participants have been waiting for something to break.

Given the vast majority of hiking cycles have historically ended in recession, that isn’t as pessimistic as it sounds. Higher borrowing costs are intended to restrict economic growth, though central banks would rather it happens gradually, producing a soft landing rather than a recession.

For fixed income investors, one of the key decisions at this stage is how long to stay invested in credit. Corporate bond spreads tend to be tight and prone to sell-offs in the latter stages of the economic cycle, just as we witnessed in early August when US unemployment unexpectedly jumped to 4.3%.

But late cycle conditions can persist for years while credit spreads suffer from occasional bouts of volatility. US high yield bonds, for example, have delivered around 15% in the roughly 14 months since rates hit their peak; getting out of credit too early can mean missing out on attractive returns.

Is this a late cycle market?

While the market consensus for now is that central banks have a good chance of pulling off the elusive soft landing, there are cracks starting to show.

At just under 3%, the US savings ratio is now comfortably and consistently below its pre-pandemic level, suggesting US households are having to dig deeper into their pay checks to meet the higher prices left behind by the post-pandemic surge in inflation.

In addition, certain cohorts are running out of steam, with delinquency rates on credit cards and auto loans picking up among lower-income borrowers. Today’s 15% delinquency rate on subprime auto loans, for example, is higher than at the peak of the global financial crisis in 2009.

However, overall US consumer spending looks to be moderating rather than falling off a cliff. Retail sales edged up 0.1% month-over-month in August, defying expectations of a 0.2% decline, following an upwardly revised 1.1% surge in July.

Accordingly, we don’t expect a sharp decline in the US economy either. According to an average of economic forecasters surveyed by Bloomberg, growth is expected to be running at around 2% in the US through the end of 2025 (see Exhibit 1). In fact, of the 65 forecasters surveyed, just two expect a US recession and only four contributors expect any negative quarterly growth numbers over the period.

Clearly, there are other areas of weakness in the global economy that suggest investors should stay vigilant.

Recent data from the Eurozone’s two largest economies, Germany and France, particularly in manufacturing, has been weak, albeit offset by much stronger growth figures in the periphery countries. In the UK, sticky services inflation has forced the Bank of England to proceed cautiously with rate cuts, while the new Labour government has warned on budget constraints. 

As Exhibit 2 shows, we think a number of indicators now suggest we are through the recovery phase and moving into late cycle.

However, that does not mean we see a recession around the corner. Instead, we see growth rates possibly falling below potential, but staying positive, which is typically a favourable environment for fixed income.

Are corporates under pressure?

In late cycle, we would typically expect to see companies getting creative with their balance sheets, issuing new debt and increasing leverage as they attempt to maintain growth in economies that are slowing down.

However, as Exhibit 3 shows, lower-rated firms in the US have been very restrained in terms of issuing bonds. Clearly yields are now higher and there is less incentive to issue, but this does demonstrate that high yield companies are not under pressure to raise capital; they took advantage of low yields in 2021 to issue cheap debt, extend their maturities and boost the cash on their balance sheets.

Where these companies have looked to borrow in the last couple of years, they have largely done so via leveraged loans, which tend to be floating rate – as rates fall, so will the issuers’ borrowing costs. Again, this suggests to us that companies are being strategic with their borrowing rather than coming under pressure.

Another metric supporting the case for credit is the net interest payments of non-financial companies (see Exhibit 4). Historically, net interest expenses tend to rise along with rates as companies pay more for their debt. In the Fed’s latest tightening cycle, however, net interest expenses actually fell, according to a July 2024 report on the US economy from the IMF.¹

The authors cite two reasons for this. One, companies were holding a relatively high level of cash; this goes back to the limited default cycle initiated by the Covid crisis, which saw weaker firms either default or restructure and prompted stronger firms to boost their cash balances for the tougher times ahead. Two, companies used the relatively brief post-Covid window of lower yields to issue longer term, fixed rate debt, meaning that while their interest income rose in line with rates, their interest payments didn’t.

Are credit spreads too tight?

As numerous commentators have pointed out, the strong performance of credit over the last 18 months has left spreads some way below their long-term averages (see Exhibit 5).

Given the macro backdrop outlined above, corporate bond spreads should be tight at present. However, that doesn’t necessarily make them unattractive. Much like late cycle conditions, below-average credit spreads can persist for long periods. In fact, spreads typically spend the vast majority of the cycle below the average, since they tend to grind steadily lower in benign markets but then spike to much higher levels when sentiment deteriorates, in moves that are sharp but short-lived.

In addition, the amount of cash sat on the sidelines could play a significant role in keeping a lid on credit spreads in future sell-offs. 

As Exhibit 6 shows, the Fed’s sharp hiking cycle has seen total assets in US money market funds rise by 40% over the last two years to $6.3tr. That trend is now slowing with only around $180bn coming in year-to-date (it was $500bn+ across 2023), while US bond funds have received over $120bn of inflows in the same period after two consecutive years of negative flows.

The vast majority of the shift thus far has unsurprisingly moved into higher quality government and investment grade bonds. But barring any significant deterioration in the macro outlook we expect growing appetite for high yield assets as well. For reference, the size of the US high yield bond index is around $1.3tr; if only a very small portion of the money market stockpile were to enter that market it could offer material support.

Yields make trimming risk relatively easy

When spreads are tight, it is easy for investors to get nervous about the potential for spread widening to hurt their returns.

This is a valid concern, since late cycle conditions typically see volatility increase as markets become more reactive to signs that economies may be slowing too quickly. As mentioned, this was evident in early August, and to a lesser extent in early September when more weak US data raised fears that the Fed’s rate cut plans were behind the curve.

However, for medium term investors we believe it is relatively easy to mitigate this risk by increasing the credit quality and decreasing the credit duration of their portfolios. 

With overall yields still very attractive in our view, it is possible to shift towards higher quality, shorter dated bonds without sacrificing too much in terms of potential return. Indeed, as the below charts demonstrate, the rewards for going down the credit curve (Exhibit 7) or further along the maturity curve (Exhibit 8) today are low relative to history.

Another prudent tactic at this stage of the cycle is to avoid cyclical sectors, which tend to underperform as the cycle ages further and certainly if economies do ultimately dip into recession.

While credit spreads may be prone to bouts of widening as markets digest new data and continually assess the likelihood of a soft landing, for medium term investors we think carry – the income achieved from holding bonds even if prices are static – can continue to deliver attractive returns in the coming months.

From a relative value perspective, our favoured sectors at the moment are financials and asset-backed securities (ABS), including collateralised loan obligations (CLOs). While we don’t anticipate a dramatic increase in default rates for high yield corporates, from a relative value point of view we don’t think yields are attractive enough to compensate for the additional risk of holding lower rated high yield bonds.

Stay prudent, but stay invested

Overall, we think this is a good time to stay invested in credit.

This is a tricky stage of an unusual economic cycle, with the major economies converging but from different directions as growth moderates from a high level in the US and picks up from a low level in the Eurozone.

Certainly, we think it is wise to be gradually moving up in credit quality and down in credit duration in order to be better positioned for what’s ahead. However, we don’t think this cycle is set to end any time soon, and therefore we see a lot of value in fixed income markets and in credit.

In our view, credit can keep calm and carry on for some time yet. If investors pick the right kind of credit exposure, we think they can expect to enjoy more of the performance we have seen over the last 18 months or so.

1 International Monetary Fund, Staff Report for 2024 Article IV Consultation (United States), 18 July 2024.