Fixed income Bonds: Where are the opportunities?

Investment grade bonds

Calm after the March madness
Sentiment improved in April as the containment of financial sector stress helped to dampen market volatility. IG credit’s relative outperformance over government bonds stalled out late in the month, but investors were able to earn carry with prices trading in a relatively narrow range. Slowing growth dynamics, deteriorating corporate fundamentals, and lingering concerns about the financial sector should remain an overhang.

However, with all-in yields still near decade highs, CIO continues to see value in IG corporate bonds. Longer-term-oriented investors entering the market now are able to lock in yields of 5% and above in intermediate-maturity bond issues. The coupon component will likely be a main contributor of IG’s total return, with some additional price upside potential should interest rates move lower.

Financial spreads wide vs. nonfinancials
As credit spreads have compressed from their mid-March peaks, IG financial spreads still stand at their widest levels relative to nonfinancials since 2012. The differential is most pronounced on the front end of the maturity curve: IG 1–3-year financial spreads are 40bps wider than their beginning-of-March levels. Meanwhile, industrial and utility sector spreads are actually tighter in longer maturities.

Focusing on bank segments, US Big 6 bank bond spreads are about 12bps wider than their beginning-of-
March levels, whereas non-US bank spreads are 25bps wider and US regional bank spreads are 86bps wider.

US bank earnings: Continuation of the same trends

Recently reported 1Q23 earnings showed that the Big 6 US banks are in adequate fundamental shape. A key focus for investors was on liquidity and deposit balances, and these metrics were in line with expectations. The large US banks benefited from the flight-to-quality sentiment brought on by the acute funding stresses facing some US regional banks. However, deposit levels are still reflecting a customer switch from non-interest-bearing to interest-bearing accounts.

JP Morgan raised its guidance for net interest income in 2023, and Wells Fargo and Citigroup confirmed prior guidance. This suggests that while deposit costs have been on the rise, they remain manageable relative to the higher asset yields. Credit quality has remained benign, with just some modest increases in loan charge-offs.

Some banks increased their loan-loss provisions on account of loan growth and managements’ incrementally weaker macro assumptions. While commercial real estate exposure is fairly diversified, banks have been setting aside more reserves to cover this exposure. Overall, despite the economic uncertainty, the big US banks are starting from a sound fundamental position.

Although there is still likely to be ongoing stresses for some US regional banks, we continue to like exposure to senior bonds of large and well-capitalized US banks. We see opportunities in select regional US bank bond issues, particularly in short-dated maturities, while focusing Big 6 bank issues in 5–10-year maturities.

High yield corporate bonds

HY spreads compress from March wides
The ICE BofA high yield index returned 1% in April and is up 4.7% year-to-date. The positive return in April is largely a result of carry as spreads remained range-bound during the month, and as the index benefited from a slight decline in the 5-year Treasury rate, to 3.5% at the end of April from 3.6% at the end of March. Spreads, however, had a strong move tighter from the 524bps wides reached on 23 March, and the index experienced an outsize total return of 2.4% from the March lows. HY spreads now sit at 455bps, which is 27bps lower than where they were at the beginning of the year, but still roughly 50bps wider than the tights reached pre-Silicon Valley Bank failure. The yield is currently 8.4%, down from over 9% in mid-March and essentially in the middle of the year-to-date range. CCCs outperformed in April, returning 2%, while Bs and BBs returned 1.05% and 0.74%, respectively.

Moved HY to neutral
We continue to believe that HY is vulnerable in a recessionary environment. This is largely because in an economic slowdown, HY companies tend to display revenue and margin weakness. In addition, the tighter lending conditions that are likely to result from the recent banking turmoil could make it more difficult for HY companies to obtain access to capital. For this reason, we are keeping our yearend spread target unchanged at 550bps.

However, absolute yields on the asset class have hovered around 8.5–9% for most of this year and provide carry. This yield level is wide by historical standards and has only been breached on four occasions since the global financial crisis. This wide level of yields offers a buffer for total returns. In fact, we calculate that yields could rise by 225bps over the next year before the total return on HY turns negative. It is due to this yield level and the carry that we moved HY to neutral.

However, we continue to believe that IG bonds can provide a better risk-adjusted return than HY in 2023. With the economy slowing, IG companies are in a stronger fundamental position and should see less downward pressure. Hence, we continue to recommend an up-in-quality bias in fixed income.

New issuance picked up
The stable market environment helped propel new bond issuance in HY. In April, USD 19bn of new issues were priced. This is up materially from the USD 5bn that were priced in March and is up 57% from April 2022. New issuance was still considerably below 2021 levels (April 2021 saw USD 57bn of new issuance), but is on par with the USD 17bn that were priced in April 2019. Year-to-date, new issuance stands at USD 58bn, essentially in line with USD 61bn in 2022 but below the USD 76bn that were priced in 2019. The reopening of the HY market is a positive signal, showing demand remains for HY debt and that corporations are able to access the capital markets.

What to do in HY
From a portfolio allocation standpoint, we advise that investors maintain a neutral allocation to HY and practice caution as the economy slows. However, for investors seeking exposure to the space, we think that short-dated maturities of solid credits that trade below par make sense in this environment. Additionally, selective exposure to noncyclical names that offer attractive yields can add alpha to a portfolio.

Main contributor: Leslie Falconio

For more, see the report Fixed Income Strategist: Preparing for a pause 2 May 2023.

This content is a product of the UBS Chief Investment Office.

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