Quick Takes on Capital Markets: Credit markets: Feeling out the tremors

With economic growth concerns mounting, fixed income investors need to consider shifting from low to high quality credit. More attractive valuations and less upward pressure on bond yields should make this transition more appealing.

Q1 2022 delivered the worst core bond performance since 1980. That weakness has extended into Q2—the Bloomberg U.S. Aggregate Bond index has now erased all gains since mid-2019.

Investors shouldn’t be entirely surprised. Historically tight spreads, low yields and inevitable monetary tightening from the Federal Reserve created daunting prospects for U.S. investment grade at the start of 2022. However, recent sharp moves have shifted the asset class’s outlook.

Valuations have become considerably more attractive since January 2022. Now, with U.S. investment grade yields not far off 12-year highs, demand from yield-based buyers (pension funds, insurance companies, etc.) should accelerate. In comparison, the yields on high yield bonds are still meaningfully below 2020 levels.

A repeat of the recent bond market rout is unlikely. With U.S. headline inflation peaking, market expectations for Fed tightening shouldn’t ratchet up significantly, and thus duration concerns have likely peaked.

Economic growth worries are mounting. The higher quality of investment grade credit, alongside U.S. Treasurys, can add an element of defensive positioning in portfolios, providing stronger downside mitigation.

Credit markets haven’t been immune to market turmoil and will be further challenged as economic growth slows. With difficult days ahead, preparing fixed income portfolios with longer duration and higher quality exposures is advisable—at least now there’s some yield to go along with it.