Our 2022 scenario for corporate bonds

Rising government bond yields and bullish equity markets mean US and euro high yield (HY) bonds outperformed their investment-grade (IG) counterparts in 2021. This year, we expect H1 to be a mirror of 2021. But our return expectations are lower for the year as a whole as credit spreads are tight by historical standards.

However, as the Fed starts its rate-hiking cycle, we would expect market participants to become more selective, especially in the HY segment, where default rates could pick up slightly from low levels. This is likely to mean wider credit spreads into year-end 2022.

We continue to favour segments where spread cushions are comfortable. One area is financials’ subordinated debt, (in particular, additional tier-1 (AT-1) instruments issued by European banks), which offers high coupons. This debt is often rated HY even though the issuers typically have an IG rating. Another is US leveraged loans, whose floating-rate features and generous credit spreads could help them outperform US high-yield bonds as monetary policy tightens. However, the ongoing transition from the LIBOR benchmark rate also represents a risk for investors, with generalised adoption of the Secured Overnight Financing Rate (SOFR) as an accepted benchmark is likely to mean reduced returns for investors. Another risk regarding leveraged loans is the rise in covenant-lite issues, which now represent 92% of leveraged-loan issuance. The rise in covenant-lite could mean a lower recovery rate in the next economic downturn.

Less accommodative central banks will mean a higher cost of debt and perhaps slower growth. But we still see opportunities in rising stars. Also, post-pandemic economic stimulus has a decidedly green hue. We therefore like ESG bonds with a focus on renewable energy, pollution reduction and sustainable-development goals.

In conclusion, we remain underweight investment-grade credit, as tight spreads offer little protection against the rise in core sovereign bond yields that we expect. We recently moved to neutral from underweight on euro HY, aligning our stance with that on its US counterpart. We remain underweight on IG corporate bonds. We expect the spread cushion in HY to be comfortable enough to compensate for rising sovereign bond yields in the coming months.