Most developed market central banks have started their cutting cycles, with the Federal Reserve (Fed) being one of the final dominos to fall following its 50 basis points (bps) cut in its September meeting. Cutting cycles have historically occurred to combat crises. In contrast, central banks are now cutting to normalise monetary policy, stimulate the economy and engineer a soft landing. We believe this provides a solid macroeconomic backdrop for the short duration corporate credit market.
Why corporate credit?
We believe that short duration investment grade (IG) corporate bonds can offer strong risk-adjusted returns, as well as an attractive carry profile during a central bank cutting cycle. Global IG company fundamentals are strong, with our analysts projecting US EBITDA (earnings before interest, taxes, depreciation and amortisation) growth to continue in the mid-single digits. Europe appears to be following a similar path to recovery to the US with a year lag, and our analysts expect the majority of sectors to show positive EBITDA growth by early 2025. Revenue growth is starting to lose some momentum, but companies have done a good job of maintaining their margins and have been making efficiencies rather than shedding labour.
We believe the technical backdrop remains strong and stands to improve as IG issues have exceeded expectations year-to-date due to a pull-forward of issuance from future quarters. Meanwhile, robust demand has absorbed the record amount of supply. We expect supply to taper as we get nearer to the US election, but do not anticipate a let up in demand with over $6.3tn sitting on the sidelines in money markets. This should provide a positive tailwind for the IG market.
From a valuations perspective, while current IG spreads are tighter year-to-date, over a longer time frame, the front end is relatively wider vs history compared with the overall index. Importantly, the all-in yields on offer in IG credit are among the most attractive over a 10-year horizon, with both US and euro IG corporates yielding at the 79th percentile over the time period. Ultimately, our base case remains a soft landing and we believe that although spreads are tight, they still have the potential to move meaningfully tighter from here.
Why does short duration make sense now?
Yields on 1 – 3 year US IG corporates and European IG corporates (~1.9 years duration) have decreased by 82bps and 55bps respectively since the start of the year, as markets have adjusted to rate cuts and tighter spreads. Yields slightly further out the curve have been less affected. For the 3 – 5 year segment of the US and European markets (~3.6 years duration), yields have reduced by 51bps and 24bps respectively. This means that a blended allocation across the 1-5 year IG corporates curve (~2.7 years duration) can mitigate the impact of the lower overall yield environment. This strategy offers potential upside if yields decline more than current market expectations or if credit spreads tighten further, which aligns with our base case of a soft landing.
Our analysis suggests that shorter duration bonds have the potential to offer attractive risk-adjusted returns, based on the possibility of price appreciation and the higher yields currently available. It is true that there is some spread give up at the shorter end of the curve , but this is more than offset by the very attractive yields on offer at the front end because of the current inversion of the Treasury curve. The short end also has the capacity to compress the most because the current inversion in this part of the curve typically narrows and then turns positive when the economy slows as investors price in rate cuts, sending shorter-dated yields down faster than the longer-dated ones.
Why is now the time to move out of cash and into fixed income?
We think the current economic environment presents an opportunity to capture additional income in the bond market. Cash is currently offering competitive yields versus the broader fixed income market, but this dynamic is set to shift. The market is now pricing in much larger cuts from the Fed and European Central Bank, bringing down cash and cash equivalent returns in the short-term.
Indeed, the current 4.8% yield on 3-month T-Bills (or 3.3% in the European equivalent) can only be annualised if investors can roll into 3-month instruments yielding the same amount in 3, 6 and 9 months’ time. With multiple central bank rate cuts expected within these time horizons, this feat seems increasingly unlikely. However, the current attractive yield levels in the corporate credit market can be locked in via adding duration through a fixed income allocation. On top of the projected potential for strong total returns within the fixed income market as central banks cut rates, we have also seen the negative correlation between equity and fixed income come back into the market, allowing fixed income to act as a diversifier within portfolios once again.
Recent market volatility has underscored the capital protection potential of fixed income and duration. Macroeconomic events, such as the July US labour market report and the Bank of Japan’s interest rate hike, have shaken financial markets, leading to increased volatility in early August. Despite this turmoil, the Global IG Corporate Index demonstrated resilience. While spreads widened, this was offset by a rally in rates, allowing the IG corporate market to maintain stable all-in yields and deliver consistent returns, even as other asset classes experienced significant upheaval.