Opinions, estimates, forecasts, projections and statements of financial market trends are based on market conditions at the date of the publication, constitute our judgment and are subject to change without notice. There can be no guarantee they will be met.
28 April 2023
Where are US investment grade credit spreads headed?
US investment grade credit spreads have recently tightened, but the potential for a recession in the second half of the year could see them widen to attractive levels. We take a closer look at the recent drivers of the US investment grade credit market and considerations for fixed income investors.
Fundamentals
First quarter earnings for US companies put US regional banks back in the headlines this week, but more broadly, investment grade credit fundamentals remain supported. With leverage ratios at cycle lows and robust earnings, most US companies have improved their balance sheets and liquidity profiles since 2019. That said, following nearly 500 basis points (bps) of rates hikes from the Federal Reserve and quantitative tightening, credit conditions have been tightening: the Fed’s quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices showed that around 45% of banks were tightening standards for commercial and industrial loans at the end of 2022. The recent US regional banking crisis has tightened credit conditions even further, and consumers and small business are finding it harder to secure loans. With the US labour market cooling and the Conference Board’s Leading Economic Index (LEI) dropping to 1.2% in March, its lowest level since November 2020, weakness appears to be starting to spread. Any continued weakness in leading indicators could signal a recession on the horizon, which may put pressure on corporate fundamentals.
Quantitative valuations
US investment grade credit yields are attractive today at 5.03% (Bloomberg U.S. Investment Grade Credit Index as of 25 April 2023) and relative to history, at close to the 80th percentile. The same cannot be said about spreads. Since hitting a recent peak of 163bps on 15 March 2023, US investment grade credit spreads have tightened by 26bps to 137bps on 25 April 2023, only 5bps higher than at the start of 2023. Interestingly, this modest overall widening has been driven mainly by the banking sector. Looking at just industrial corporate spreads, they are actually tighter since the start of the year. With the recent downturn in leading economic indicators, US investment grade credit spreads are only pricing in around a 30% chance of a recession. Our base case is for the market to start pricing in a recession in the second half of 2023. In that scenario, US investment grade spreads could widen to over 200bps, which could provide an attractive buying opportunity.
US investment grade credit spreads have tightened from the recent peak on 15 March 2023
Source: Bloomberg, J.P. Morgan Asset Management; data as of 25 April 2023.
Technicals
Technicals remain strong for US investment grade credit. We expect a seasonally robust May, absent more macro volatility, with an estimated USD 115-125 billion of US investment grade credit supply, which is well above April’s likely total of approximately USD 60 billion. This increased supply is evidence of strong demand for the asset class, where a combination of inflows to high grade funds, overseas demand for US and European corporate bonds and relatively defensive positioning will allow supply to get placed in the market. That said, as recessions risks rise, spreads could widen, which could be a headwind to demand. Recent investor positioning surveys suggest investors are preparing for a recession and looking to add to US duration positions.
What does this mean for fixed income investors?
US investment grade corporate fundamentals remain robust. That said, lending surveys and leading economic indicators are pointing towards a slowdown in the US economy in the second half of this year. If this plays out and market conditions continue to deteriorate, then US investment grade credit spreads are expensive at current levels. As a recession approaches, we would expect to see spreads widen from current levels, which could present an attractive buying opportunity. In this environment, across our multi sector portfolios, we remain positioned up in credit quality in corporate allocations, while overweight US high-quality duration.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors
include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations
is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors
are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum
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