Credit markets ended 2023 with strong total returns. 

At the end of October, this outcome looked unlikely in investment-grade markets, given the volatility in underlying government bond yields. Since then, November proved to be the biggest positive total return month for US investment-grade bonds since 1982. Spreads tightened and Treasury yields fell on a growing consensus that the Federal Reserve had paused its rate-hiking efforts.

November was also the third-biggest month for easing in global financial conditions since 2008. As can be seen in the chart below, credit spreads have tightened, bar a brief but marked wobble in March around regional US bank issues and the collapse of Credit Suisse. Indeed, using global BBB-spreads over Treasuries as indicative, we have now broken through the longer-term average level of 170 basis points (bps).  

Chart 1: Global BBBs  Govt OAS (bps)

Chart 2: Global BBBs Yield to Worst (%)

Source: abrdn, Bank of America Merrill Lynch indices, 15th January 2024

Previous cycles are useful indicators

We would argue that markets are behaving exactly as history would dictate. If interest rates peaked in late July 2023, then previous cycles tell us that total returns for investment-grade markets in the ensuing 12 months should be strongly positive. It also tells us that credit spreads tend to be stable-to-tighter in the same time frame, as this is normally before the point a recession hits. Since late July, US investment-grade markets have returned +4.5% (as of 16th Jan 204) and spreads over Treasuries have tightened by 23bps (18%). Now that corporate spreads are inside historical averages, are credit markets becoming increasingly complacent?

Scenario 1: a soft landing for credit markets?

We see three potential scenarios for credit markets in the future. The first one is the most aligned with current market expectations: a ‘soft landing’. For this to play out, we need a predictable slowdown in inflation and growth. We also need pre-emptive central banks that ease interest rates as the cycle progresses to accommodate the soft-landing process. If this environment is achieved, we expect further strong total returns for investment-grade and high-yield markets. A note of caution: this outcome has rarely been achieved, with the exception of 1995. The current strong demand for credit could lead to further spread tightening in the short term, but spreads will start to look ‘rich’ at that point.

Scenario 2: is a hard landing likely?

The second scenario is a ‘hard landing’ – a recession where growth slows much faster than the soft-landing discussed above.

With this potential outcome, the next question is always what type of recession, or depth of recession, are we likely to experience? We still believe a recession in the U.S. can’t be ruled out next year, although it's likely to be mild. On balance, we see developed-market corporates as well-placed to weather this, and we expect a fairly low default cycle, which should protect returns to an extent. Although not our base case, a deeper recession will of course lead to a more pronounced default cycle impacting returns from the high yield market. While most spread relationships are currently moving below their long-term averages, such as the spread differential between BB-rated high yield bonds and BBB-rated investment-grade bonds, this isn’t the case in the lowest-rated category of CCC (see chart below). This shows that while the market is currently trying to price in a soft landing, risk and caution remain in certain areas, given the threat of a potential US recession. 


Chart 3: CCC less Single-B spreads (bps)

Source: abrdn, Bank of America Merrill Lynch indices, 31st December 2023.

In every recession, spreads move comfortably north of 200bps over Treasuries in investment-grade markets. Demand for credit is structurally higher than it has ever been, driven by pension funds and aided by other investors coming back to the asset class because of the attractive all-in yield. Perhaps spread widening can be more contained than in the past, but considering the current spread of 100bps in early January, this does give pause for thought.

Scenario 3: higher-for-longer?

The final scenario is ‘higher-for-longer', which we define as central banks maintaining interest rates at elevated levels for longer than the market expects. This can’t yet be ruled out if inflation remains sticky and there is no noticeable slowing in the US labour market, although this is the least likely scenario. The correlation between Treasury yields and real yields with risk-assets, including credit spreads, remains high. Therefore, in the latest moves, falling yields lead to increased demand for credit and spread tightening. The ‘higher-for-longer’ scenario, though, would necessitate a rise in yields and a widening in credit spreads, although not to the extent we should expect in a recession. The sting in the tail with this scenario is that the odds of a recession further out rise as do the odds of an even deeper recession. While investment-grade issuers will be able to navigate the maturity wall coming in 2025, the high-yield market will struggle more if yields are moving higher again.

Balancing risk and opportunity 

In the event of scenario 1, fundamentals would remain robust and credit spreads are likely to tighten further. We should also see reasonable total returns helped by underlying government bond yields.

However, while not impossible, a ‘soft landing’, using history as a guide, is  improbable. Consequently, spreads could move wider at some point under scenarios 2 or 3. Balancing the risk and opportunities, we currently favour investment-grade markets, but believe there will be opportunities to add to government bond exposure in 2024, before looking a little further out  for a more attractive entry point to allocate more to high yield.