Corporate bonds regaining appeal

For the past few weeks, issuers that had made themselves scarce in the primary market since the start of the year have been returning to the floor. Among them are companies from non-financial sectors, particularly utility companies and industrial firms. The new issues, especially those placed by companies with robust business models, have proven very popular with investors. Data collated by Union Investment’s proprietary global credit platform (GCP) shows that, on average, these transactions were six to eight times oversubscribed.

This strong demand from investors can be seen across all sectors. A look at the performance of recently-issued bonds reveals that spreads have narrowed (to varying degrees) in absolute terms since the relevant placement dates. Examples include issues placed by travel platform Booking.com, Italian Bank UniCredit, French construction company Bouygues, Schneider Electric and Honeywell. On average, spreads narrowed by between 15 and 25 basis points in the first few weeks following placement.

The yield trend, meanwhile, provides a clue as to why investors are rediscovering their appetite for corporate bonds. While ten-year Bund yields reached 2.05 per cent in mid-November – already a fair margin above fixed-term deposit interest rates – investment-grade corporate bonds are now yielding around 4 per cent (ICE BofA Euro Corporate index).

The positive performance of new paper after placement shows that investors’ risk aversion is also easing off somewhat. In the last few years, the prevailing environment of low interest rates had forced many investors to shift more and more towards lower-rated paper in order to generate a reasonable return for their portfolio. Now, it has become easier again to achieve attractive returns on new paper from solidly-funded companies that nonetheless comes with a manageable duration – an important point against the backdrop of persistent macroeconomic challenges.

GCP data also shows that many investors are now using new issues as an opportunity to regain exposure to longer maturities. Until recently, market participants had largely been focused on reducing the duration of their portfolio. But now, longer-dated paper with maturities of nine to eleven or even up to 20 years is attracting growing interest from investors again.

What is driving this latest change of fortunes in the corporate bond market? The investment decisions of market participants are partly based on the assumption that the US Federal Reserve (Fed) and the European Central Bank (ECB) might soon take the foot off the accelerator with regard to interest-rate increases. The Fed’s cycle of rate rises looks set to at least proceed at a slower pace than the most recent jump of 75 basis points, which was the second consecutive hike by this margin. In addition, growing signs of an economic downturn are keeping the interest-rate markets supported. The credit markets, meanwhile, are being buoyed by a third-quarter reporting season that turned out better than investors had expected.

However, market conditions will probably remain volatile. Corporate bonds seemed to be heading for calmer waters on multiple occasions in recent months, only to then find themselves buffeted by fresh turmoil. Whether or not high interest-rate volatility can be ushered out this time while keeping credit spreads at reasonable levels is going to depend to a large extent on inflation. The trajectory of inflation rates will determine the level at which the central banks ultimately conclude – or at least suspend – their cycle of interest-rate increases. Prices of options on US treasury futures imply that the market expects the pace of rate hikes in the US to slow down significantly in the near future.

Union Investment’s experts also believe that inflationary pressures will ease next year, not only because of the economic slowdown (that the central banks are deliberately inducing) but also because of year-on-year effects. As time goes by, the months that saw the steepest price spikes in sectors such as energy and commodities will progressively drop out of the inflation calculation. Delayed effects of rising interest rates should also help to slow down inflation, as should the easing of the supply chain problems that is now evident.

The current trend suggests that the bond market has now largely adjusted to the shifts in growth, inflation and monetary policy. As a result, the upward pressure on yields of safe-haven bonds should also start to abate. However, uncertainty around these key parameters remains high, as risk factors such as the war in Ukraine persist and continue to fuel volatility.

This makes a selective approach all the more important. Although market participants have recently started to rebuild their exposure to longer-dated paper, investment-grade bonds with shorter to medium-term maturities remain our preference as their combination of decent yields and limited interest-rate risk offers a partial buffer against any further interest-rate rises and price falls. In addition, high-quality issuers should face limited fundamental risks even in a deteriorating macroeconomic environment, as these large businesses can absorb the effects of higher costs more easily. High inflation could even prove beneficial to them, because stronger nominal revenue growth typically leads to a stabilisation or even a slight fall in the debt ratio of companies with a well-working business model.

At sector level, the financial sector continues to benefit from rising interest rates and the resulting prospect of higher net interest income. Real estate, which had been eschewed by investors in recent months due to the sharp upward trend in interest rates, could now bottom out, provided the economic slowdown does not turn into a severe recession. The focus will likely be on residential property rather than retail real estate.

By contrast, cyclically sensitive sectors such as consumer discretionary (clothing, entertainment, automotive) should be treated with caution in light of the prevailing macroeconomic risks. And sectors that are strongly affected by the energy crisis are currently also best avoided. Broadly speaking, this primarily encompasses the chemicals and industrial sectors.

As at 11 November 2022.