Corporate Credit Outlook: Focus on Quality

After a difficult 2022 so far, we generally have a more positive outlook on the corporate bond market for 2023. We believe the worst is behind us for investment-grade corporate bonds and preferred securities, but we expect volatility—and more potential price declines—in high-yield bonds and bank loans.

Our theme for the new year is "quality." With economic growth expected to slow and recession risk still high, we suggest investors focus on higher-rated investments. Rather than reach for yield in the lower-rated parts of the market, we'd rather focus on those with investment-grade ratings and the relatively high (often 5% or higher) yields they tend to offer. There may be better opportunities in 2023 within the riskier parts of the market—like sub-investment-grade, or "junk," bonds—but they are likely to see price declines before they get there, which would be painful for those holding these investments.

Federal Reserve policy and tighter financial conditions are key risks. Once rates become restrictive, that should slow demand and in turn slow economic growth. Corporate profit growth should be challenging over the next few quarters, as well. Corporate profits actually declined in the third quarter of 2022, according to the Bureau of Economic Analysis, and with borrowing costs on the rise and consumer spending likely to slow, we don't expect much growth in the next few quarters.

If corporate profits remain stagnant or continue to decline, we believe high-yield issuers are more at risk than investment-grade issuers. High-yield issuers tend to have weaker balance sheets and more volatile cash flows, so when corporate profits slow, there's little wiggle room for many issuers to remain current in servicing their liabilities. And as economic growth slows, the number of high-yield defaults should keep ticking higher.

Here's a quick summary of our views. Below, we provide more details about the various parts of the bond market, highlighting some areas of opportunity and some potential pitfalls.

Investment-grade corporate bonds appear attractive given the rise in yields during 2022. Despite our economic and corporate profit growth concerns, we believe investment-grade corporate bond issuers should be able to hold up well. Their balance sheets are strong because they were generally able to lock in low interest rates over the last few years, and they tend to have more stable cash flows than high-yield issuers. Most investment-grade rated issuers have more diversified funding sources, and their bond maturities tend to be spread out. If an investment-grade issuer needs to refinance a maturing bond at higher yields today, it will likely have a smaller impact on the issuer's overall interest than it would for most high-yield issuers.

The average yield-to-worst of the Bloomberg U.S. Corporate Bond Index is now above 5%, down from just over 6% in October. Aside from that recent high, yields are still at the highest levels since 2009, and other than the surge in 2008 and 2009, yields are not too far below their 20-year highs. In the five years leading up to the 2008 financial crisis, the average yield of the index was 5.2%, very close to the current levels. Investors don't need to wait for higher yields with investment-grade corporate bonds, because they are already here.

There are still risks of course. Spreads—that is, the amount of yield compensation corporate bonds offer above comparable Treasuries—could rise modestly higher as economic growth slows, but we expect any potential rise to be small. We expect Treasury yields to fall in 2023, which could offset some of the possible spread widening and help keep prices supported.

We're much more cautious on high-yield bonds, for three key reasons:

1. Spreads are relatively low. Corporate bond yields are generally composed of a Treasury yield plus a "spread," referenced above, meant to compensate investors for the risk of investing in riskier bonds. The average option-adjusted spread of the Bloomberg U.S. Corporate High-Yield Bond Index is down to just 4.4% after rising to 5.8% over the summer.

At 4.4%, the average spread of the index is right near the 10-year average of 4.3%, but we believe risks are elevated today. Investors should consider high-yield bonds when they are being compensated appropriately, but that's not the case today.

2. Spreads tend to rise leading up to a during a recession. The chart below highlights that spreads are well below previous peaks hit over the last 20 years and that spreads are usually higher when we enter a recession as the gray shaded areas illustrate. If growth slows as we expect, spreads should rise.  

High-yield bonds tend to perform poorly when the yield curve (the difference between shorter- and longer-term yields) is inverted. The 2-year/10-year Treasury yield curve has been inverted since July, while the 3-month/10-year yield curve only dropped below zero in November.

The table below illustrates the 12-month excess returns (return relative to Treasuries) of the Bloomberg U.S. Corporate High-Yield Bond Index depending on the starting slope of the 3-month/10-year yield curve. The steeper the curve, the better the returns have been, while a flat or inverted yield curve has resulted in average excess returns below zero. We expect the yield curve to remain inverted as the Fed keeps hiking rates.

Given those concerns, we'd exercise caution with high-yield bonds and wait for better entry points later in 2023. As economic growth slows and recession risk remains elevated, spreads should rise—pulling prices down—as investors demand higher yields to compensate for those risks. Both Moody's and Standard & Poor's expect high-yield defaults to pick up over the next 12 months from their very low levels, which usually results in poor performance as well. We prefer investment-grade rated bonds now and would wait for better entry points next year for high-yield bonds.

Preferred securities appear attractive for investors who have long investing horizons and can ride out some potential volatility. We don't expect prices to rise much in the near term, however.

The average yield-to-maturity of the ICE BofA Fixed Rate Preferred Securities Index is above 7% for the first time in more than a decade, and average prices have rarely been lower. Average coupon rates remain low at roughly 5%, so most issuers don't have much incentive to "call" (i.e., redeem) their preferreds.

Preferred securities have long maturity dates, or no maturity dates at all, but the issuers can usually "call" them after a specified period of time has passed. With market yields generally higher than the coupon rates on outstanding preferreds, it doesn't make economic sense to refinance preferreds today. In other words, most issuers wouldn't voluntarily issue a new preferred with a 7% yield in order to retire a currently callable issue with a 5% coupon rate, because that would increase the issuer's cost of servicing their preferreds.

We don't expect prices to rise much in the near term as a result, but we still believe that preferreds still look attractive given their high yields. Banks and financial institutions are large issuers of preferreds, and we believe their fundamentals generally remain strong. Slow economic growth might eat into their profit margins, but we believe most major domestic banks are well-capitalized given the financial regulations put in place after the 2008 financial crisis. We believe the risk of dividend suspension for investment-grade preferreds is low.

Bank loans are a type of corporate debt with sub-investment-grade, or "junk," credit ratings. They are secured by a pledge of the issuer's assets and have floating coupon rates. They're usually only available to large institutional investors, so for most individual investors the only way to access the market is through a mutual fund or ETF.

We believe bank loan prices are at risk of modest price declines in 2023 given their low credit ratings and exposure to rising interest rates.

There are pros and cons to bank loans' floating coupon rates. For investors, it means that income payments tend to rise when the Fed hikes rates. But it also means that bank loan issuers are hit with higher interest payments in real time. For most corporate bonds, coupon rates are fixed, so issuers are only at risk of higher borrowing costs if or when they need to issue new debt. That's not the case with bank loans because their coupon rates frequently reset.

Given the aggressive pace of rate hikes, the interest expense of most bank loans has risen sharply. In 2021, for example, the average coupon rate for the bank loan universe was roughly 3.5%, assuming a short-term reference rate of just above zero and average spreads of 3.25% to 3.5%. With the federal funds rate now in the 3.75%-to-4% range, the average interest expense for many loans has doubled, and it should keep rising as the Fed hikes rates.

Given the rising input and labor costs already burdening many corporations, rising interest expense is one more factor that can eat into corporate profit margins. Like high-yield bonds, bank loan prices may fall modestly lower from here, but total returns may still be positive as higher income payments may offset some of the price declines. Like high-yield bonds, however, we believe there could be better entry points down the road.