Two years ago, central banks began implementing aggressive monetary tightening measures to control the expansive financing conditions put in place during the pandemic. These actions helped prevent a major economic crisis by curbing the wave of defaults in credit markets.
Thanks to a robust economic recovery, corporate fundamentals have returned to pre-Covid levels. This, coupled with higher yields, has drawn investors back to the corporate bond market, yielding returns of 8.40% for US Investment Grade (IG) and 13.50% for High Yield (HY) in 2023.
However, as the economic cycle progresses and uncertainties surrounding Fed easing, geopolitical risks, and tight credit valuations persist, investors need to consider their position in fixed income markets.
The credit cycle involves the cyclical pattern of credit availability and pricing within an economy, influenced by economic conditions, monetary policy, and market sentiment. The current US credit cycle is likely in the expansion/late cycle phase, marked by declining economic growth and inflation, prompting the Fed to maintain its restrictive policy.
This scenario is expected to further tighten financial conditions, with US corporate bond yields nearing 15-year highs. Despite the renewed interest in corporate debt, credit spreads have tightened significantly, potentially reducing refinancing risks for issuers. However, there are signs of a slight deterioration due to higher borrowing costs and slower earnings growth.
While defaults are not expected to surge immediately, recent data shows an increase in global defaults, primarily in lower-rated credit segments. S&P projects a US speculative debt default rate of up to 4.75% by year-end, with a pessimistic scenario suggesting a rate of 6.75% in the event of a recession and persistent inflation.
Regarding fixed income portfolios, caution is advised given the potential for a harder landing in the current monetary tightening cycle. With the Fed hinting at higher rates for longer, volatility in rates and credit markets is likely to persist. Historically, tight valuation levels suggest a prudent approach, favoring high-quality IG corporate bonds and US Treasuries to reduce credit risk.
As the Fed’s policy stance evolves, investors should remain vigilant and adjust their portfolios accordingly to navigate potential market disruptions.