As governments have gone on a debt-financed spending spree, businesses have shown greater financial discipline.
The era of high interest rates is coming to an end. Just as demand for solid, stable income streams begins to increase as baby boomers retire, the traditional sources of such returns – money market funds and sovereign bonds – may be in short supply. Investors will have to look further afield, and we believe credit could provide the answer.
Initial valuations of corporate debt look very attractive: at 5.9%, the starting yield on mid-rated US corporate bonds is close to the highs seen in the aftermath of the 2008-09 credit crisis, both in absolute terms and relative to equities. Investors will have a good chance of locking in this level of yield for the next five years, especially with very manageable levels of risk.
As governments indulged in a debt-financed spending spree (pushing up the pressure on maturity premiums), businesses demonstrated greater financial discipline. They have debts close to their historic lows, abundant liquidity on their balance sheets and healthy interest rate coverage ratios.
Net leverage and interest coverage ratio over 4 rolling quarters of US high yield securities
Source: JP Morgan, Pictet Asset Management. Net leverage is defined as the ratio of net debt to EBITDA, interest coverage is defined as the ratio of EBITDA to interest expense. Data covering the period from 01.01.2008 to 31.12.2023.
We expect leverage and interest rate coverage to remain broadly stable over the next five years as solid corporate earnings growth offsets slightly higher financing costs and management remains relatively cautious about share buybacks and M&A. We also expect inflation to be slightly above average, which will help companies maintain high margins.
The default outlook is relatively low: we expect an average default rate of 2.7% over the next five years. While interest rates have peaked in major economies, market access for borrowers is expected to continue to improve, creating opportunities for early refinancing. This could in turn push high-yield bond prices back up toward par. Such an increase typically occurs as maturity approaches, but could now occur earlier, particularly at the short end of the market (known as “pull-to-par” performance).
Another positive point is the expected relative stability of the macroeconomic situation: we expect low but continued growth. Although it limits earnings growth prospects for stocks, it could bode well for credit.
Benefits for wallets
Finally, let’s not forget the advantages that credit offers in terms of asset allocation. Historically, it has better risk-adjusted performance than government bonds and lower maximum losses than stocks. From an examination of typical risk profiles of global US dollar balanced portfolios, our analysis shows that adding global high yield securities to the risk (equity) allocation as well as global investment grade securities to the Risk-free allocation (bonds) significantly improves the performance of a portfolio, while maintaining the same notional risk allocation and portfolio volatility.
These features will likely be even more attractive as the negative correlation between government bonds and equities—to which investors have become accustomed in recent years—becomes more unpredictable in a context of increased inflation volatility and higher maturity premiums. This could undermine the ability of sovereign debt to serve as a buffer in a portfolio.
In such an environment, instead of seeking diversification in assets with negative correlations, investors should instead aim for high and stable income that will allow them to better absorb equity risk in the medium term. In our view, this is precisely what credit offers, with the added benefit of superior diversification to the equity market, both through the more uniform sector representation it offers and through the reduced dominance of a handful of very large companies.
For all these reasons, we see strong potential in credit markets over the next five years. We expect emerging market credit, as well as US and European high yield bonds, to perform in line with global equities (at around 7% per year), but with potentially lower risk and volatility. Investment grade credit should not be far behind, providing even greater certainty of obtaining the required income.
