CIO’s most preferred view on IG isn’t based on further spread compression but rather the ability to earn incremental carry over US government bonds. (UBS)

The biggest change when comparing the current IG curve shape with the beginning of the year is the move higher on the short end. This was primarily driven by the shift in the US Treasury curve, with the 2-year Treasury yield climbing higher by 48 basis points year-to-date. CIO maintains a barbell allocation of both the short-end (1–3 year) and intermediate (7–10 year) parts of the curve. The short end provides low-volatility carry, while longer duration should be beneficial from a total return standpoint as Treasury yields eventually decline.

Credit spreads touched a new year-to-date low of 119bps on 28 July. CIO’s most preferred view on IG isn’t based on further spread compression but rather the ability to earn incremental carry over US government bonds. We believe investors can afford to assume narrow spreads because the high levels of Treasury yields give them the potential to rally in a risk-off market event and offset credit spread widening. In the meantime, coupon carry is gradually becoming a more prominent component of IG returns. At present, the market-weighted coupon for the IG index is 4%, up from the historical low of 3.65% in early 2022. On fundamentals, the 2Q23 earnings reporting season has provided confirmation to the generally solid status of the most influential IG issuer credit profiles. CIO's view that 2Q23 should mark the trough in the year-over-year earnings decline for the S&P 500 also bodes well for IG corporate constituents.

The market's risk-on mood in July helped drive BBB spreads tighter by 14bps, which exceeded the 10bps of tightening for single A’s. But more than just ratings beta at play, industry sector composition was also a driver of performance as financial spreads outperformed within both ratings cohorts. BBB financials tightened by 27bps in July, which outpaced a narrowing of 15bps for BBB industrials. Similarly, single-A rated financials tightened by 17bps, outpacing a narrowing of 9bps for single-A industrials.

Several sector-specific factors propelled financials in July. These include: 1) earnings results for the US regional banks helped to calm any remaining crisis-of-confidence fears in the sector; (2) Fifth Third was the first category IV regional bank to issue new debt since before March, and it was met with very strong investor demand; 3) consolidation between two regional banks in California was announced without government assistance and with private investment plugging the capital holes of the transaction; and 4) the final interpretation was released for the Basel III regulations for US banks, where regulatory requirements will be increased for banks down to USD 100bn in assets.

Despite the recent strong performance for US IG financials, they still trade cheap relative to their nonfinancial counterparts on a duration-matched basis. We continue to see strong relative value in this sector, and among US banks in particular. This holds true across both A's and BBBs. The spread pickup for moving down in credit rating from A's to BBBs is tight from a historical perspective, but it is wider for banks compared to industrials. Since 2010, the spread ratio of BBBs/A's stands at the 43rd percentile for banks but just the 29th percentile for industrials.

Main contributor - Barry McAlinden

Original report - IG corporate bond insights, 2 August 2023.