(Bloomberg) -- Investors should look to bonds for income and as a hedge to equities again after fixed-income assets suffered a “horror show” first half, Vanguard Group Inc. said.
The $7.1 trillion money manager sees the TINA mantra -- there is no alternative to equities -- as a thing of the past with a weakening economy likely validating bonds as a portfolio diversifier, the firm’s fixed-income team led by Sara Devereux wrote in a note on Monday.
“Corporates, municipals, high yield, and emerging markets present more opportunity than any time in the recent past,” according to the Vanguard team.
US corporate investment-grade and high-yield bonds had their worst first half ever amid rising inflation, higher interest rates and recession fears. High-grade risk premiums breached a key threshold that analysts and investors say could start to disrupt the flow of credit, while high-yield spreads to comparable Treasury maturities widened to the highest since 2020.
Spreads needed to rise to compensate investors for the downside potential of the Federal Reserve’s aggressive rate policy, though not all segments of the credit markets have priced in these concerns fully, wrote the fixed income group.
Still, “as the Fed’s path forward becomes clearer, there are many security selection opportunities to take advantage of that do not subject our funds to large downside risks,” Devereux and her team wrote.
‘Crosshairs of a Recession’
Average spreads on euro-denominated high-grade company bonds rose above 200 basis points in mid July, compared to 95 basis points at the start of the year. US high-grade risk premiums have widened by about 58 basis points in the same period. U.S. market valuations don’t yet reflect the full set of risks on the table, but pockets of value are apparent, according to Vanguard.
“European valuations screen as cheap, but there’s little dispersion across sectors and the region is in the crosshairs of a recession,” they wrote. “A selective approach is appropriate.”
Vanguard sees the best risk-reward scenarios in higher rated bonds and has moved away from cyclical sectors and toward companies with more earnings stability. The team expects borrowers with low liquidity needs and strong balance sheets to hold up.
The fundamental credit picture for junk-rated companies remains strong even in the face of a likely economic slowdown ahead, said Vanguard. US junk bonds are poised to post the biggest monthly gains in two years and the CCC tier, the riskiest part of the US market, is on track to post its first monthly gain this year and the biggest in 20 months, with a 3.34% month-to-date return.
While downside economic scenarios are generally not friendly to high yield, the market has improved in quality compared with years past, with the BB rated segment of the sector now representing more than half of the universe, up from 35% before the global financial crisis, wrote the team. Default rates, meanwhile, remain around 1%, well below the historical average of 3.5%, and leverage levels are back to below pre-pandemic levels.
“Companies appear to be well situated to manage a difficult economic environment, but security selection can ease downside risk,” they wrote.
‘Better Positioned’
A slower global growth outlook, plus Russia’s invasion of Ukraine and some social unrest have all weighed heavily on emerging-market bond prices, sending yields on US dollar-denominated credit in the sector above 9%, according to the investment company’s report. Historically at these yield levels, expected returns for a year ahead are quite strong, Vanguard said.
“We feel EM debt is further along in its adjustment, and better positioned for recovery, than many other asset classes,” the strategists wrote.
Elsewhere in credit markets:
Americas:
Six companies are selling bonds in the US investment-grade primary market on Monday, anchored by the financial sector. Royal Bank of Canada, Truist Financial, Fifth Third Bancorp, Capital One Financial and American Express all announced new debt deals, with pipeline operator Kinder Morgan the lone non-financial issuer.
- Estimates for the week suggest new-issue volume reaches $15 billion to $20 billion, most of which is expected to be announced prior to the Federal Reserve’s interest rate decision on Wednesday.
- US junk bonds are poised to post the biggest monthly gains in two years, with a month-to-date return of 4.3%, after edging higher for three weeks, the longest winning streak since December. That would make July only the second month this year with positive returns.
- IXS Holdings Inc., which makes industrial spray-on protective coating, has struggled with operating performance as it confronts high inflation and production delays in the automobile industry, S&P Global Ratings said.
- For deal updates, click here for the New Issue Monitor
- For more, click here for the Credit Daybook Americas
EMEA
Europe’s primary bond market cranked into gear following the European Central Bank’s rate hike last week, with four issuers emerging Monday to market five tranches in Europe’s publicly syndicated debt market to raise a minimum of 2.44 billion euros.
- SSE Plc is reviving Europe’s limping green bond market with its first euro sale of the notes since 2018
- The company has opened books on seven-year green bonds, increasing the size of the deal to 650 million euros ($664 million) after order books topped a hefty 3.8 billion euros
- Ukraine’s state-owned oil and gas company plans to prepare a new debt-relief plan after failing to get bondholders’ approval for its last-minute proposal to freeze payments on about $1.4 billion of bonds
- The European Central Bank may not be done with big increases in interest rates after surprising with an initial half-point hike last week, according to Governing Council member Martins Kazaks
- Senior managers at JPMorgan Chase & Co.’s investment banking arm say they’re taking market share from competitors by continuing to underwrite deals, as other lenders retreat due to widespread losses
Asia
Asia’s primary dollar bond market sustained its momentum Monday, with three issuers, including two Chinese firms and a Japanese borrower, marketing debt after an unusually busy week.
- Japan Post Holdings Co. is planning a yen green bond sale that would be its first corporate note deal since the mammoth postal firm was formed in 2007 as part of a privatization move
- Rupee corporate bond sales are set for their best week in roughly 10 months on expectations that elevated borrowing costs already factor in multiple interest rate hikes by India’s central bank
- The clock is ticking for the world’s most indebted developer, China Evergrande Group, whose liquidity woes sparked a broader debt crisis in China’s property industry that’s gone on to engulf more home builders, threaten banks and pose growing challenges for President Xi Jinping
- Two companies in China’s property industry saw their domestic bonds become worthless when pledged for loans in the exchange-traded market last week, offering another example of the rising credit stress in the sector