Investment-Grade Corporate Bonds: Signs of Life After Worst First Half in History
Continued rate volatility due to Fed policy and economic data will provide entry points throughout the quarter.
The investment-grade debt markets continued to struggle in the second quarter, as volatility in rates and equities, coupled with recessionary fears and uncertainty around Fed monetary policy, remained heightened. Technicals such as fund flows and overseas buying started to deteriorate, but the good news is that fundamentals remained positive.
Investment-grade corporate credit spreads continued to widen in the second quarter, which crystalized the worst half performance for investment-grade credit in history. Over the quarter, the Bloomberg U.S. Investment-Grade Corporate Bond Index widened by 40 basis points to 155 basis points, resulting in -7.26 percent total return and -2.24 percent in excess return. This brought the total return performance for the first half of the year to -14.19 percent.
Investment-grade weekly fund flows were negative every week in the second quarter. We would expect these outflows to continue throughout the third quarter, albeit at a declining rate. Overseas buyers, both euro and yen, experienced a dramatic increase in hedging costs, which resulted in muted demand for corporate bonds. These deteriorating technicals put outsized pressure on the intermediate credit curve, while support for longer duration remained strong.
Corporate bond liquidity also struggled in the first half. Year-to-date cash volumes were down 1 percent while derivative/exchange-traded fund (ETF) volumes were up 37 percent year over year as of June 30. Derivatives and ETFs tend to be used for more macro hedging, while cash trading typically addresses fundamental concerns. The dichotomy in these volumes highlights investors’ concerns over the macro backdrop versus the micro/fundamental backdrop.
Continued rate volatility due to Fed policy and economic data will provide entry points throughout the quarter. The 10/30s credit curves flattened over the second quarter due to rising Treasury yields and strong buying from investment companies, pension funds, and other institutional investors. We believe this trend will continue in the third quarter, with a focus on long duration, low-dollar price corporate bonds. With banks maintaining strong capital ratios, the bank preferred market looks historically attractive as well. As rate volatility subsides, we believe that the preferred market should start to see positive inflows and outperform.
Dollar Price Corporate Bonds Will Likely Attract Investors
Source: Guggenheim Investments, Credit Suisse, BAML, Bloomberg, ICE BofA. Data as of 6.30.2022.
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Investing involves risk. In general, the value of fixed-income securities fall when interest rates rise. High-yield securities present more liquidity and credit risk than investment grade bonds and may be subject to greater volatility. Asset-backed securities, including mortgage-backed securities, may have structures that make their reaction to interest rates and other factors difficult to predict, making their prices volatile and they are subject to liquidity risk. Investments in floating rate senior secured syndicated bank loans and other floating rate securities involve special types of risks, including credit risk, interest rate risk, liquidity risk and prepayment risk.
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