Investment grade returns have been historically driven by income, and 2024’s total returns are expected to follow this pattern. We maintain that higher yields, supported by “higher for longer” rates and Treasury yields, should result in satisfying total returns.
We don’t expect material spread changes during 2024 as fundamental and technical factors are generally favorable, which should mean that credit spreads remain close to their historic averages. In light of this, and today’s high yields relative to history, we expect returns to be consistent within some reasonable range around starting yields for investment grade corporate credit. Below we show the fairly tight relationship historically between starting yield and five-year forward total return.
Figure 1: Starting Yield drives total returns expectations: Today’s higher yields help
Source: Bloomberg US Aggregate Corporate Index; Data from Jan 1, 1973 to Nov 22, 2023. It is not possible to invest directly in an index. See disclosures at the end of this document. Past performance is not indicative of future results.
Benign environment for investment grade credit with respectable fundamentals
Investment grade companies will enter 2024 with generally healthy balance sheets as higher interest rates have lessened the desire to take on more debt to fund higher payouts to equity holders or engage in debt funded M&A. The numbers bears this out; investment grade non-financial issuers have reduced shareholder payouts (dividends and share buybacks) by 5% year-on-year (-12% excluding the commodity sectors).1 Overall, we expect corporate leverage to remain anchored at its current 2.6x (gross debt to EBITDA) as management teams are expected to remain generally cautious and intent on controlling their cost of capital.
Positive Technical: Increasing credit quality
The quality of the investment grade corporate market has improved in recent years. As a result of companies’ improving financial resiliency and control over debt metrics, the percentage of the investment corporate market that is BBB is now just 47%, down from a peak of 51% in 2018. Furthermore, the share of BBB- in the index, the level just bordering on high yield, has dropped to an 11 year low of 10.7%. This improving trend is expected to continue into 2024, though at a slowing pace. 1
Figure 2: Upping the quality: BBB are shrinking as a % of overall Credit Index
Source: Bloomberg
Positive Technical: Less supply, more demand
Supply of corporate debt is expected to shrink in 2024. That’s good news for investors. Annualized 2024 supply of investment grade bonds should be lower by 1% year-on-year on a gross basis and down 24% year-on-year on a net basis, according to JP Morgan. Should this forecast prove correct, it would be the slowest growth rate for the investment grade market in terms of net issuance since 2011. One sector that is expected to issue more bonds in 2024 compared to 2023 is the financial sector, notably the larger US banks and regional banks, with the latter expected to issue more debt to satisfy anticipated regulations requiring them to hold more loss absorbing unsecured debt.
Figure 3: Less Supply of Investment Grade Bonds as Higher Rates Take Effect
Source: JP Morgan
Figure 4: More Demand for Investment Grade as Yields Are Attractive
Source: eVestment
Demand for investment grade bonds is expected to remain positive
We expect demand for investment grade debt to remain positive for the foreseeable future. The highest yields in more than a decade and solid fundamentals support the asset class despite generally fairly valued credit spreads.
Sector Selection to augment returns
Entering 2024, while credit spreads are broadly fair, we believe a few sectors offer compelling value.
The telecommunications sector is interesting as the larger wireless companies come to the end of their costly 5G network roll-outs and revert to more maintenance capital spending. This likely means these companies will issue less debt and financial leverage should be restrained.
In the financial sector, the largest sector in the market, the implementation of further regulations is expected to benefit bond investors and may ultimately mean regional banks experience credit rating upgrades. However, before that happens these banks will need to issue sizable amounts of debt, likely resulting in wider credit spreads. With thorough financial analysis and proper security selection, we view this as an opportunity to add higher yields with compelling total return potential to an investment grade portfolio.
Eye on possible sources of risk
The full impact of higher interest rates on the economy has likely not been fully experienced given the long and variable lag of monetary policy. As is typically the case, we expect the effects to be felt greatest by lower-rated companies, especially those with considerable floating rate debt, that have higher leverage and face near term liquidity needs. Investment grade companies are less levered and typically have debt service coverage ratios of 9x-11x, offering greater resilience should the economy take a turn for the worse. Furthermore, investment grade companies did a good job terming out their debt maturities when interest rates were much lower, suggesting near term liquidity needs appear more manageable.
In sum, we think investment grade credit markets in 2024 present an attractive opportunity for investors to earn high income from a diversified asset class with solid fundamentals and a strong technical backdrop, which should offer resiliency should economic growth fail to meet already diminished expectations.
1 Source: JP Morgan
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Past performance is not indicative of future results.
COMPARISONS TO AN INDEX
Comparisons to a financial index are provided for illustrative purposes only. Comparisons to an index are subject to limitations because portfolio holdings, volatility and other portfolio characteristics may differ materially from the index. Unlike an index, individual portfolios are actively managed and may also include derivatives. There is no guarantee that any of the securities in an index are contained in any managed portfolio. The performance of an index may assume reinvestment of dividends and income, or follow other index-specific methodologies and criteria, but does not reflect the impact of fees, applicable taxes or trading costs which, unlike an index, may reduce the returns of a managed portfolio. Investors cannot invest in an index. Because of these differences, the performance of an index should not be relied upon as an accurate measure of comparison.
Source Information
“Bloomberg®”, “Bloomberg Indices®”, Bloomberg Fixed Income Indices, Bloomberg Equity Indices and all other Bloomberg indices referenced herein are service marks of Bloomberg Finance L.P. and its affiliates, including Bloomberg Index Services Limited (“BISL”), the administrator of the indices (collectively, “Bloomberg”) and have been licensed for use for certain purposes by MacKay Shields LLC (“MacKay Shields”). Bloomberg is not affiliated with MacKay Shields, and Bloomberg does not approve, endorse, review, or recommend MacKay Shields or any products, funds or services described herein. Bloomberg does not guarantee the timeliness, accurateness, or completeness of any data or information relating to MacKay Shields or any products, funds or services described herein.
The following indices may be referred to in this document: Bloomberg US Aggregate Corporate Index
BLOOMBERG US AGGREGATE BOND INDEX
The Bloomberg US Aggregate Bond Index is a broad-based index that measures the investment-grade, US dollar-denominated, fixed-rate taxable bond market, including Treasurys, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities, with maturities of at least one year. Index results assume the reinvestment of all capital gain and dividend distributions.
BLOOMBERG US AGGREGATE CORPORATE INDEX
Bloomberg US Aggregate Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by US and non-US industrial, utility and financial issuers.
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