Head of Fixed Income Strategy
Summary: On average, Investment-grade (IG) bonds don't provide any protection against rising inflation. Our analysis finds that to beat it is necessary to pick an average duration of 15 years, exposing a portfolio to further interest rate risk. Not only, but the bonds that offer the highest spread are found within the lowest investment grade category (BBB-). Safety can be found within the technology space, while the consumer discretionary space offers a better risk-reward ratio. Finally, we look at the new United Airlines bonds (BBB-), which for an average life of 3.2 years provide around 4% in yield.
Fixed-income investors have a clear strategy for this year: seeking coupon income to create a buffer against rising US Treasury yields.
However, it is easier said than done. As a matter of facts, spread compression is pushing investors towards riskier assets and longer maturities.
Since last December, the average yield offered by US dollar investment-grade companies has fallen below the 10-year Breakeven rate. It means that better quality bonds, on average, don't provide a yield high enough to protect against inflation, explaining the sudden rush towards higher-yielding bonds.
However, junk bonds don't look any better. While US corporates' leverage is the highest in nearly 20-years, the average yield offered by CCC rated companies – the riskier tier of junk – has fallen to the lowest level in history. According to Bloomberg Barclays indexes, the junkiest corporate bonds now pay on average a yield of 6.5%.
Best risk-return tradeoff is found in the consumer discretionary sector. Utility and Industrial sectors offer the worse bond opportunities
When looking for opportunities in the investment-grade (IG) corporate bond space, one will find that it is necessary to either pick bonds in the lowest-rated segment (BBB-) or extend the duration to an average of 15 years to build a buffer against a rise in interest rate. Thus, IG corporate bonds inevitably expose ones' portfolio to downgrade and interest rate risk. Under this perspective, the junk space (HY) seems to offer better opportunities to hedge against inflation, allowing investors to pick up bonds with a yield above 2.5% with an average duration of nearly four years.
Technology appears to be the healthiest sector offering the lowest average net-debt-to-Ebitda and one of the highest interest coverage for both investment and high-yield companies. However, it provides one of the lowest option-adjusted spreads (OAS): around 76bps and 313bps for IG and HY bonds, respectively. Suppose you are looking for a yield above 2.5%. In that case, you will find that it is necessary for you to go as long as 16.5 years to get that yield in the high-grade space. Still, if you look at junk bonds, you will need to pick up an approximate duration of 3.3 years only. It is important to note that although the sector's average spread is low, it is still possible to find exciting opportunities. For example, DELL 2030 (US24703DBD21) offers a yield of 2.7% for a modified duration of 7.32, which is around half of the industry’s average.
The consumer discretionary sector provides the best opportunities in terms of risk and reward. While the sector's OAS is above average, the net-debt-to-Ebitda is modest while still providing high-interest coverage. In this space, it is necessary to go as long as 14.5 years in duration to find IG bonds paying a yield above 2.5%. In comparison, the duration can get down to 3.5 years when looking for a minimum of 2.5% within high yield bonds. It will be interesting to know that among these borrowers, it is possible to find Ford Motors. The recently fallen angel is offering around 2.7% in yield for just two-year maturity.
The charts below shows which sector offers the highest OAS (bubble size) relative to corporate's leverage and interest coverage.
The sector that offers the worst value within higher-rated bonds is the utility sector providing an average OAS of 97bps and the highest net-debt-to-Ebitda and lowest interest coverage. Besides, it is necessary to go as long as 16 years in duration to get a yield above 2.5%.
In the junk bond space, the industrial sector offers the worst opportunities providing an above-average OAS, but very high leverage.
As hot as it gets: United Airline's new bonds
The hunt for yield becomes more and more complex as bond prices continue to rise. Consequently, investors are willing to open up to unconventional bond issuances such as the United Airlines we have seen this week. United was able to place $600bn of secured sinkable bonds backed by older aircraft and spare parts and engines with an average life of 3.2 years (US90932VAA35). The collateral was enough for the issuance to secure an investment-grade rating opening up demand from many institutional investors that otherwise wouldn't have been able to bid for the bond. The order book swelled with orders above $6 billion, and although indicative price talks (IPT) were indicating a yield in the high 5% region, the issuer was able to secure a yield almost 100bps lower at 4.875%.
United Airlines' new issuance is a clear example of investors' desperation to find yield within the investment-grade space. Although the issuer is junk and these types of bond structures have traditionally been used to finance new aircraft rather than repaying outstanding loans, investors are willing to overlook these technicalities to secure a yield is impossible to find in the IG space. Don't get me wrong, I like this bond myself, however, seeing the bond pricing 100bps cheaper than IPT, and now the street reselling it for another 100bps point slower, makes me think that the run for yield has just started. Late joiners will simply have to pay more.
2024: The wasted year
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
Markets are driven by election optimism, overshadowing growing debt and liquidity concerns. The 2024 elections loom large, but economic fundamentals and debt issues warrant cautious investment.
As US economic slowdown hints at a shift away from exceptionalism, USD faces downside with looming Fed cuts. AUD and NZD set to outperform as their rate cuts lag. JPY gains on carry unwind bets and BOJ pivot.
Amid AI and obesity drug excitement, equities see varied prospects: neutral on overvalued US stocks, negative on Japan due to JPY risks, positive on Europe. European defence stocks gain appeal.
With the economic slowdown, quality assets will gain favour, especially sovereign bonds up to 5 years. Central banks' potential rate cuts in Q2 suggest extending duration, despite policy and inflation concerns.
Commodities poised for rebound. The "Year of the Metal" boosts gold and silver, copper awaits rate cuts. Grains may recover, natural gas stabilises. Gold targets $2,300-$2,500/oz, copper's breakout could signal growth.
