The era of high interest rates is coming to an end. Just as the demand for strong and stable income streams is starting to pick up thanks to the retirement of baby boomers, traditional sources of such returns – money market funds and sovereign bonds – are likely to fall short. Investors will have to look further afield, and we believe credit could be the answer.
Initial valuations for corporate debt look very attractive: at 5.9 per cent, the starting yield for an average-rated US corporate bonds is close to highs reached following the 2008-9 credit crisis both on absolute terms and relative to equity. Investors could do a lot worse than locking in that level of yield for the next five years – particularly at very manageable levels of risk.Based on BAA-rated bonds as of 30.04.2024
While governments have indulged in debt-funded spending sprees (resulting in rising pressure on term premium), corporations have shown greater financial discipline, with corporate leverage near historic lows, abundant cash on balance sheets and healthy interest rate coverage ratios (see chart).
US high yield trailing 4-quarter net leverage and interest coverage ratio
Source: JP Morgan, Pictet Asset Management. Net leverage defined as net debt/EBITDA, interest coverage as EBITDA/interest expense. Data covering period 01.01.2008-31.12.2023.
We expect both leverage and interest rate coverage to remain largely stable over the next half decade as solid corporate earnings growth offsets modestly higher funding costs and as company management remain relatively conservative when it comes to share buybacks and M&A. We also expect inflation to be slightly higher than average, helping corporates to sustain high margins.
The default outlook is relatively benign: we forecast a 2.7 per cent average default rate over next 5 years. With interest rates in major economies having peaked, market access for borrowers should continue to improve, creating opportunities for early refinancing. That, in turn, could lead to the prices of high yield bonds rising towards par value – something that usually happens as maturity approaches, but could now occur sooner, especially at the short end of the market (known as the pull to par return).
Another positive is that the macroeconomic backdrop should remain fairly stable: we expect low but steady growth. While this limits earnings growth prospect for equities, it could prove good news for credit.
Portfolio benefits
Last but not least, there are the benefits that credit offers from an asset allocation point of view.
Historically, it has better risk adjusted returns compared to government bonds and smaller peak-to-trough falls versus equities. Looking at typical risk profiles of global balanced portfolios in US dollar terms, our analysis shows that adding global high yield to the risk allocation (equity) and global investment grade to risk-free allocation (bonds) notably enhances portfolio return, while keeping both the notional risk allocation and portfolio volatility the same.
We expect returns for US and European high yield to be on a par with those for global equities, yet potentially with less risk and less volatility.
These characteristics are likely to become all the more valuable as the negative correlation between government bonds and equities – to which investors have become accustomed in recent years – becomes more unpredictable in the face of greater inflation volatility and higher term premiums. This in turn may undermine sovereign debt’s ability to act as a shock absorber in a portfolio.
In such an environment, instead of seeking diversification from negatively correlated assets, investors should look for high and stable income to better dampen equity risk over the medium term. We believe credit offers precisely that, with the added benefit of being more diverse than the equity market, both in terms of having even representation of sectors and in terms of being less dominated by a handful of corporate giants.
For all these reasons, we see strong potential across credit markets over the next half a decade. We expect returns for emerging market credit, as well as US and European high yield bonds, to be on a par with those for global equities (at around 7 per cent a year), yet potentially with less risk and less volatility. Investment grade credit shouldn’t be far behind, with yet more certainty of delivering the required income.
