Risk warning

The value of investments, and the income from them, can go down as well as up and an investor may get back less than the amount invested. Past performance is not a guide to future results.

Corporate bonds are back, and the time is ripe for a Fixed Income Explained Podcast credit special.

What are the factors driving credit markets? Where can investors find best value? What’s the outlook for the remainder of 2024? And are there any risks on the horizon?

Fixed Income Explained host Peter Marsland returns to tackle all these questions and more, with the help of an array of abrdn corporate bond experts.

Listen in as Peter chats with credit colleagues Siddharth Dahiya, Ben Pakenham, and Louise Smith, in a conversation spanning investment grade corporates, European high yield and emerging market debt.

Is it time to invest in credit? Find out now. 

Podcast

Peter Marsland: Welcome to abrdn’s fixed income explained podcast. I'm Peter Marsland, a fixed income investment specialist at abrdn, and today's episode is all about credit. Credit spreads reflect the extra yield demanded by investors to compensate them for the additional risk of lending money to a company rather than the government.

Since the start of the year, credit spreads have moved lower to relatively tight levels. Today we'll be exploring what factors have driven credit spreads tighter. And what is the outlook for the remainder of 2024? Joining me to discuss this topic is Louise Smith, an investment director focused on global investment-grade (IG) bonds. Ben Pakenham, head of European high yield and global loans, and Siddharth Dahiya, head of emerging market corporate debt. So, expertise across the globe and capital structure.

A warm welcome to all of you. And thank you for joining me today. So, let's start with the bigger picture and start with you, Louise. What has driven spreads tighter so far this year?

Louise Smith: Thank you sir, thank you for having me. I was just going to start with a little bit about the economic backdrop and then move on to some credit specifics. So we've seen mild recessions in Europe and UK. But really, it's all been about what's been happening in the US.

So extremely resilient growth, GDP expected to be above 2% this year, and inflation has remained very high. So in Q1, it was 3.7%. So albeit it's come down from the high single digits that we have had, is still pretty elevated and well above the Fed’s 2% target.

We know some of the reasons for this. So, strong labour market and headwinds also from geopolitics with the oil price remaining at relatively high levels. That all sounds quite negative. But our economists do see some modest signs of disinflation. So just last week, there was some of the data showing slowing wage growth, and then expecting lower market rents to come through as well. So we should see that coming through as we move into the second half of the year.

The Fed just last week reiterated the higher for longer narrative. And encouragingly they have said that they don't expect to be doing any further rate hikes. From an abrdn perspective, we're expecting two Fed cuts later this year, and for the ECB and the Bank of England to start cutting in June.

So all in all, we feel that the economic backdrop is quite supportive for bond yields. Moving on to corporates, so probably most importantly, we feel that the fundamentals are still quite strong. Margins are very high, interest coverage is above its long-term average. And we're encouraged that we're seeing some pretty conservative behaviour from company management.

So they're reducing capex, reducing buybacks, and that's all leading to quite strong balance sheets. From a valuation perspective, yields are at a decade-high. So if you look at the corporate indices, they're yielding around about five and a half percent. That's in the US, but similar in the UK, and a little bit lower in Europe. So what we are expecting is pretty decent returns across most scenarios. It does mean as well, that credit looks quite attractive versus other asset classes. So the yield is around 2% above equity dividend yields. And we do have to acknowledge, as you said, at the start of your podcast, Peter, that spreads are looking quite tight, they have compressed significantly over the last six to nine months.

So for example, in the US index spreads are at 86 basis points, and that's come down from a range of about 120 to 150 last year. So mitigating reasons for this: quality of the indices have increased with triple B's making up a smaller percentage of the index. And the duration has fallen as companies are not wanting to issue long-dated debt into higher yields. And that's not to argue that spreads are cheap, but we do think we probably need a shock for them to widen significantly from here. Technicals give a very strong backdrop. So we've seen strong inflows into investment grade credit with inflows up 23% year-to-date. And interestingly, annuity sales have reached record highs in the US. And of course, most of this is predicated on the overall yield. So overall, with that in mind, we’d definitely be expecting to make more in investment grade funds from yields falling than credit spreads tightening materially from here.

PM: OK, thanks, Louise. All sounds pretty supportive from an investment grade perspective. But moving down the capital structure, is it a similar story in high yield, Ben?

Ben Pakenham: Yeah, I mean, I think it's easy to perhaps overplay the return profile of the market sort of feels stronger than it actually is. I think so in a global basis. We've returned about one and a half percent year to date, and it's a bit less than 2% in Europe, specifically. So it's not been a huge performance year so far this year. But I guess the key is that that's happened in the context of government bond yields performing pretty poorly or government bonds performing poorly themselves.

So as that yield has increased, the spread has tightened as that underlying yield has increased, the spread has tightened. And that's really, I suppose, a function more than anything of the technicals, which is that, say the obvious seeing a lot more buyers than sellers. And that's leading to tighter spreads.

And the market has shrunk quite significantly over the last two, three years in Europe, I think we're down by more than 20%. And that's also playing a role. On top of that the fundamental picture has remained more resilient, I would say than many expected. So corporate earnings have been more elevated than people thought, with the inflationary pressures that came through, margins have been maintained. That's been a big surprise for many people, and ultimately, I think is a function of the consumer strength that we've seen. And that's allowed companies to pass on their inflationary pressures to a much better degree than many expected.

And as a result of that earnings strength, default expectations haven't materially increased. And of course, in high yield, spreads are predominantly compensating us for default risk and defaults are not expected to be, you know, not expected to spike in any major way in the near term. And there's also I think, just finally, the sort of self-fulfilling nature of lower yields themselves, as yields decline on highly levered balance sheets, the implied forward cost of debt for those companies declines. And again, that means that your expected default risk declines.

And all of those things actually arguably mean that spreads should be tighter. So if your default risk is declining, your spread should be lower. So that's a very positive feedback loop that we're also seeing at the moment.

PM: OK. Well, thanks, Ben. So it sounds like it's again, a pretty supportive environment for that sort of benign default outlook that has been forecast. Broadening the scope to bring in emerging markets (EM). What's happened across your universe, Sid, within corporates?

Siddharth Dahiya: Yeah, sure Peter, thanks for having me. So I would, I'd echo a lot of the points that Louise and Ben have made already in terms of the global macro and how it impacts our market. But there are a few, I'd say distinctions in EM, and one of the main distinctions is that in EM across many different countries, it is clearly visible that the hiking cycle is over. So many countries in EM actually started cutting rates, which is very dissimilar to developed markets (DM).

I think, much of the volatility that we've seen in recent months in DM markets have been on the back of expectations of cutting and when it starts, etc, whereas in EM in some countries, it has already started. The other factor that I would say is that EM has faced quite a lot of idiosyncratic issues over the last few years, the defaults in the lower-rated sovereigns in Africa, or the Chinese property market, or, you know, Russia and Ukraine.

And all of those things are now very much in the rearview mirror, have been kind of washed out of the market and don't really impact the market anymore. The other thing that I would mention, which is somewhat similar to what Ben and Louise have said, is, is the technical picture but on technicals, specifically for us in EM, it's not the demand technicals, which are strong, I mean, we've had record outflows from EM in the last couple of years.

It's actually the supply technicals, which are extremely positive in EM. So, just to give you an idea, a couple of years ago, we had net negative supply of about $250 billion from within EM, this is a big number, more than 10% of the outstanding market size, and there is no end in sight, you know, we are seeing negative net supply every year.

The one of the other factors I would mention is within our EM market, the high yield portion of the market which is a between 40 to 50% of the market. There is no real maturity wall for the next few years.