Attractive Yields But Narrow Spreads: The Credit Dilemma

Attractive Yields But Narrow Spreads: The Credit Dilemma
By Arif Husain, Head of International Fixed Income and Chief Investment Officer, Fixed Income at T. Rowe Price

Even after the late-year “Santa” rally, all-in yields in many credit sectors are near multi-decade highs, making it tempting to portfolio managers to have overweight credit allocations to maximise the yield opportunity. But credit spreads are relatively narrow and the distinct risk of an economic or financial market recession looms eventually, so managers might opt to underweight credit sectors.

What’s the solution to this portfolio construction dilemma? I think the answer is to lean even more heavily on the work of credit analysts to selectively find positions that offer attractive spreads and yields relative to their fundamental credit quality.

Lulled into complacency by near-zero defaults

Some fixed income investors may have been lulled into credit risk complacency by the near-zero default rates that have dominated the markets since the global financial crisis (GFC) of 2008–2009. Even following the worldwide economic shutdown at the onset of the pandemic in 2020, default rates did not spike as various government fiscal support programs bridged the gap to financial health for most corporations. I still think that a global recession in 2024 is more likely than not, which would push the number of defaults meaningfully higher.

Many corporate debt issuers were able to take advantage of rock-bottom interest rates in 2020 to refinance their higher-rate debt. But almost four years later, some corporations may face a “wall” of maturing bonds that will require them to tap the markets for funding. In the event of a financial markets recession—which I view as even more likely than an economic recession—credit spreads would widen, driving the cost of new issuance up and potentially increasing the debt burden for corporations.

Prefer high yield bonds, bank loans

Taking a broad view of the corporate credit sectors, high yield bonds and bank loans (which also typically have non-investment-grade credit ratings) could be areas to take risk. The credit quality of high yield issuers has steadily improved since before the GFC. As of November 2023, 53% of the global high yield bond market[1] was BB rated, up from only 38% at the beginning of 2004. While high yield bond credit spreads are not notably wide on a historical basis, their combination of improved credit quality and attractive yield can provide a good source of credit exposure, although comprehensive credit analysis is still essential as global growth slows.

But we have also been finding some opportunities in short-maturity investment-grade corporates. Yields in this short-dated segment are actually approaching those on long-term corporate bonds, providing attractive carry paired with less credit and interest rate risk as a result of their shorter maturity. The long-dated end of the investment-grade corporate market, especially in the U.S., appears distinctly unappealing for those who are not forced to buy in this area.

A new credit segment: Blue bonds

One specific area of credit investing that we have recently started analyzing is blue bonds. These provide funding for ocean health and water resource management projects, which are sorely needed to help address the degradation of ocean and inland water ecosystems. Sovereigns, development banks, quasi-sovereigns, and corporations can all issue blue bonds to raise capital dedicated to closing the funding gap for projects seeking water-related environmental benefits.

While blue bonds currently account for only a tiny slice of the global fixed income market, the sheer size of the “blue economy” (sectors connected to oceans) and the problems facing it indicate that the blue bond market could grow substantially.

Estimates from the United Nations Environment Programme Finance Initiative show that ocean-linked sectors contribute $2.5 trillion to the global economy, supporting over 30 million jobs. Increasing water demand and supply problems worldwide have led to water accessibility challenges for about 2 billion people. Faced with that data, it’s hard to argue against selectively participating in this essential new segment of the credit market.

[1] J.P. Morgan High Yield Bond Index Global.