Coming down the mountain: Why the descent from peak interest rates should be favourable for corporate bonds

In September, we wrote that it was a pivotal moment for corporate bond investors, with central banks not quite ready to declare victory in their fight against inflation.

In subsequent months, however, the data has mostly continued to cooperate, falling back towards targets in a relatively symmetrical fashion, as we can see in Figure 1. Falling energy prices were of particular help. For example, crude oil futures peaked at nearly $94 per barrel in September, but finished the year at $72¹.

Accordingly, central banks have been able to hold policy rates at their current levels for several months. Now, they are even beginning to think about reducing them. For many, a dovish press conference from the US Federal Reserve in December was the “bell” they were listening out for, signalling a pivot to monetary policy easing. The market is now expecting the first cuts to come in the first half of 2024, as shown in Figure 2.

The expectations of imminent policy easing also prompted strong demand for both duration and risk assets, which saw very strong rallies across government bonds, credit and equities as we approached the end of the year. In the first few days of 2024, we have seen some retracement, as US data have come in hotter than expected and monetary officials have sought to downplay the chances of early rate cuts.

So, while valuations may not look quite as attractive as they did previously, we still think that the conditions for corporate bonds are favourable. There are several reasons for this, which we explore now.

1. Fundamentals are reasonable

On both sides of the Atlantic, leverage has risen from a low point in mid-2022, but doesn’t look excessive on a ten-year view, as we can see in Figure 3. 

Consensus estimates for 2024 suggest earnings per share growth of around 7.5% for the S&P 500, reflecting the continued momentum for the US economy. Meanwhile the figure is a more modest 1% for the Euro Stoxx Index. Investment grade does not need spectacular economic growth to deliver returns, since the universe tends to have relatively strong balance sheets and free cash flow.

2. All-in yields remain above historical averages

We can see in Figure 4 that, while yields did retrace sharply in December, they still remain above the long-term (25 year) average and are comfortably higher than post-financial crisis levels. They also sit above equity dividend yields (1.5% for the S&P 500, 3.2% for Stoxx) and expected inflation (about 2-2.5% for both US and Europe, based on 10-year breakeven rates2).

3. High starting yields give a margin that can cushion shocks along the way

While central banks seem to have reached an apex in their policy rates, several officials have noted that cuts will be dependent on inflation reaching targets and staying there. Thus, with markets expecting more than 150bps reduction in policy rates in the US and EU for 2024, there is a material chance that the outcome may be less dovish than this. One of the chief threats to the scenario is a resurgence in energy costs, driven by escalating conflicts in the Middle East.

The Bloomberg Global Aggregate – Corporate Index began 2024 with a yield of 4.76% and a spread of 118bps over Treasuries. Figure 5 shows a range of scenarios for government yields and credit spreads and, in the majority of these, total returns for the index would be positive. The main catalyst for losses would be a sharp rise in interest rates to over 4.7% or a doubling of spreads to over 200bps, as was last seen in 2020. The breakeven for total yield change, whether it be from spread or Treasury components, is approximately 77bps.

It is worth noting that, historically, interest rates and credit spreads tend to have an inverse relationship. In other words, if government yields do rise again, we would expect spreads to tighten and vice-versa. Our central expectations would therefore lie along the bottom left to top right diagonal.

We would also expect these returns to exceed cash, as short-end rates are likely to fall through the year. Full currency hedging would add around 40bps to the starting yield in USD and 20bps in GBP, but detract around 100bps in EUR.

To conclude, we think that there is a window of opportunity in corporate bonds, with the environment looking favourable for returns in 2024 as policy rates fall. Longer term investors may also have a limited time to lock in the historically high prevailing yields.