Will 2024 be the year of corporate bonds?
The Fed's rate hike maneuvers appear to have come to an end and at the moment no rate cuts are expected for 2024, given the still solid macroeconomic data. Will 2024 be the year of corporate bonds? Analysis by Natalie N. Trevithick, head of US Investment Grade Corporate strategies at Payden & Rygel.
How to overcome market uncertainty and find investment opportunities in 2024? 2023 was an interesting year for corporate bonds, initial forecasts assumed a significant cash flow, with very profitable coupons and 5% yields. Although that level was reached quickly already at the end of the second quarter, we subsequently saw a reversal of the trend, due to the increase in interest rates. However, there is no shortage of good news: the 1-30 year corporate index is up 3.3%.
In terms of spreads, at the beginning of the year investment grade companies were 130 basis points behind Treasuries, while currently they stand at 21 basis points less. The interesting aspect is that, although rates have fallen dramatically, the demand for corporate bonds has accelerated in the last two months, probably due to the fact that the market believes that the Federal Reserve's rate hike cycle has now come to an end .
As regards the corporate yield curve, the latter did not record significant movements during the year, remaining flat. Short-duration corporate bonds, one to three years, are hovering around a 5.75% yield, while long-duration corporate bonds, up to 10-plus years, are yielding 5.82%.
What is the outlook for 2024? Our macroeconomic forecasts are positive: the Fed should have effectively finished its rate hike maneuvers and, looking at the still solid macroeconomic data, we believe that there will be no rate cuts in 2024. The labor market, in fact, is still in good health, as well as the steady GDP growth that occurred in the third quarter, although the forecast for the fourth quarter could be much more modest.
This is a rather favorable scenario for investment grade companies and 2024 could prove to be a very fruitful year. In fact, if interest rates remained at high levels, even if far from the maximum levels, many coupons would be collected, with average returns of 5-6%. Furthermore, if the Fed does not opt for a rate cut, it would mean that the economy is enjoying excellent health and therefore the spread should not increase.
Currently, company fundamentals remain solid and the sharp rise in interest rates has not had a significant impact on overall costs. As for investment grade companies, no major changes are expected in their supply forecasts for 2024.
Overall, therefore, 2023 proved to be a positive year for businesses. Maybe by the end of the year we will not reach those 5% returns initially expected and will be closer to 4%, but we think that in 2024 there will be an additional push, which should bring us closer to 6%. Considering history, this appears to be a significantly positive return for a very safe asset class.
From an overall returns perspective, 2023 was also a solid year for the high-yield bond market. Various macro factors contributed to the strong performance, first of all the stability of corporate profits, which beat expectations. As of today, the high yield market is up about 8.5%, returns that few expected earlier this year and which prove attractive and competitive with the potential long-term returns of equities.
The forecasts for next year are also positive and are based on several factors. First, it is believed that market fundamentals will remain strong, as will the balance sheets of companies which are overall well prepared for a possible recession. If an unexpected decline in earnings occurs next year, most of these companies are well positioned to weather the storm.
Furthermore, when talking about perspectives, it is useful to refer to the historical context. Investors think the main risk for high yield is a spike in defaults and a material erosion of capital, but history tells us that in the absence of a major exogenous shock or clear mismanagement of capital structures, it is rather It is rare to see large spikes in defaults, and there is no evidence that they are occurring at this time.
Obviously it is difficult to make an assessment on exogenous shocks, but the basic forecast for 2024 is that a substantial surge in the default rate is very unlikely. It is thought that a gradually increasing baseline level of defaults will be maintained in 2024, and that modest erosion of ratings and fundamentals will continue to occur, but this erosion will occur from historical highs, simply back towards historical averages.
Investors should not consider this as a loss of attractiveness for the asset class, but only as a natural reversal of trend following an extremely low interest rate environment. However, rising capital costs are not expected to have a significant impact on cash flows for most issuers, given the health of balance sheets. It is therefore believed that there will be good opportunities for active managers to identify bonds with attractive values for their investors.
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/il-2024-sara-lanno-dei-corporate-bond/ on Mon, 01 Jan 2024 06:25:35 +0000.