Hawkish perception of Fed policy in the fourth quarter resulted in the Bloomberg U.S. Corporate Bond Index hitting a peak yield for the year of 6.13 percent. This led investment-grade corporate bond investors to broadly start deploying cash. Despite seeing the wides in spreads and highs in yield for the year in the fourth quarter, investment-grade spreads tightened over the fourth quarter, while all-in yields rallied 12 basis points to 5.42 percent over the quarter. Unfortunately, this fourth quarter rally was not enough to save the sector from its worst full-year total return performance in history of -14.8 percent.
We expect the fourth quarter 2022 technical tailwinds for investment-grade corporate spreads to continue in the first quarter of 2023. Traditional money managers and insurance company portfolios continue to carry heavy cash balances, while pension fund rotations into the sector should continue. At the same time, the primary market will likely see lower gross and net issuance as investor preference for low dollar-price bonds in the secondary market and all-in higher yields will continue to support further strength in investment-grade corporates. Absolute yields are attractive relative to both historical corporate bond index standards and equities.
As we begin 2023, we are starting to see the market’s focus shift to credit fundamentals through earnings releases and forecasts. Corporate credit fundamentals are likely to deteriorate as the economy shows signs of weakening, although balance sheets are starting from a much stronger position than in prior recessions. We also expect that the effects of quantitative tightening will be felt throughout 2023.
The tight range between the widest and tightest credit spreads in the index—also called the dispersion—implies that the market is not fully priced for a downturn that would affect some industries and issuers more than others. In fact, the ratio between the widest and tightest industry spread is just 1.7x currently, below the historical average of 2.7x and well below recession peaks. This lack of dispersion across investment-grade credit spreads presents an opportunity to reposition portfolios ahead of a likely recession. As we move into this next phase of the credit cycle, dispersion should increase materially to reflect varying degrees of credit deterioration, and we are opportunistically moving up in credit quality, as well as adding to shorter maturity bonds, specifically U.S. banks, through first quarter primary market issuance.
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