Looking for ‘safe’ carry

US and euro corporate bond yields have risen sharply year to date, driven both by wider credit spreads and higher sovereign bond yields. According to the ICE Bank of America Merrill Lynch US investment-grade (IG) and high-yield (HY) indices, yields on average have reached 3.94% and 6.54%, respectively (on April 12).

The surge in corporate bonds yields is likely to prolong the period of higher funding costs for corporates while the lagged effect of higher rates, coupled with the surge in commodities prices and less accommodative fiscal policies are likely to weigh on US and euro area GDP growth in H2.

However, the fundamentals (i.e. coverage and net leverage ratios) of non-financial IG-rated companies remain solid in the US. As such, we expect IG companies, and in particular US ones, to be relatively well placed to navigate the current challenging environment and to deliver positive expected returns by year-end.

Taking stock of the more challenging environment for companies we have revised up our year-end spread forecasts in our central scenario. We expect US and euro IG spreads to widen slightly from current levels, to 130 and 140 bps, respectively, by 31 December. With a number of HY companies looking potentially less resilient, we expect US and euro HY spreads to widen more significantly to 450 and 470 bps, respectively, by the end of this year.

Thanks to their floating-rate features and generous credit spreads, US leveraged loans have outperformed US HY bonds year to date. This outperformance could continue, given that the US Federal Reserve (Fed) will probably hike the Fed funds rate aggressively. However, with US leveraged loans’ total return performance could suffer somewhat should discount margins widen in sympathy with US HY spreads as per our year-end projections.

We have moved from underweight to neutral on global and US IG corporate bonds to take advantage of higher carry. By contrast, the slowdown in GDP growth we anticipate in H2 makes us wary of HY corporate bonds, so we are moving both global and US HY from neutral to underweight.