If the widely anticipated recession in the US will take place, then US investment grade corporate bonds could prove a good place to be, Capital Group’s Flavio Carpenzano says
In 1990, Australia was faced with an environment of high interest rates as central banks sought to unwind the excesses and rapid asset price increases of the 1980s, while at the same time the stock market experienced a significant slump.
By November of that year, it became clear that Australia was in the midst of a severe recession, instead of the anticipated soft landing.
The then Treasurer, Paul Keating, explained the situation with the now legendary words: “This is a recession that Australia had to have.”
Today, the United States finds itself in a similar situation, where interest rates are high in order to battle rampant inflation after a decade of cheap capital and the impact of the global pandemic on supply chains.
This time, a recession has been widely anticipated. But instead of the recession-we-had-to-have, so far it has been the recession-that-hasn’t-happened.
“It’s definitely an interesting market environment, where we had probably the most telegraphed recession in history, yet this is a recession that didn’t happen,” Flavio Carpenzano, Investment Director at Capital Group, says in an interview with [i3] Insights.
However, the risk of a recession is still there, Carpenzano says, which means investors would do well to take a cautious approach to fixed income investing.
It’s definitely an interesting market environment, where we had probably the most telegraphed recession in history, yet this is a recession that didn’t happen
“Many in the industry, including myself, still think a recession might happen, but clearly, the economy has been quite resilient,” he says.
“Now, if you think about this scenario, where you have either a recession or a slowdown in the economy, in terms of relative value between high yield and investment grade, investment grade might offer better value,” he says.
If a recession were to happen, then US high yield credit would be much more impacted than US investment grade credit, Carpenzano expects, simply because the spreads would widen a lot more in high yield credit.
“In investment grade, you would definitely see an increasing spread, but the magnitude would be much lower because here we’re talking about companies that are much more resilient,” he says.
High yield also tends to have a much shorter duration than the investment grade corporate market in the US, which makes it less sensitive to interest rate changes. This was a good place to be last year, when rates were hiked dramatically and over a relatively short time frame, but in times of a recession, where interest rate cuts might be back on the table, it doesn’t work so well.
“If we move into more of a recessionary environment, then at some point the US Federal Reserve might start to cut interest rates, perhaps in 2024. If this were to happen, having duration in the portfolio would be beneficial,” Carpenzano says.
Inflation at its Peak
Last year was a tough one for bonds. The S&P 500 Investment Grade Corporate Bond Index plunged 15 per cent during 2022, a result not only of the magnitude of the rate rises by the US Federal Reserve that year, but also by the speed of those hikes and low starting yields.
For a long time, central banks considered the increase in inflation to be transitory, caused by the disruption of the global coronavirus pandemic. But when they realised that inflation was here to stay, they were behind the curve and had to rapidly catch up to contain inflation.
“If you consider that the yield of US investment grade corporate credit moved from around 1.5 to 2 per cent in 2021, to 6 per cent now, that is a big move,” Carpenzano says. “But also, the speed of movement was brutal.”
The low starting yield meant that bond investors did not have protection from a coupon, or income, to soften the blow. “If you put these three factors together, it was really the perfect storm for fixed income.”
Yet, 2023 is shaping up to be a very different year. In the US, inflation has reached its peak and is starting to slow down. This could mean we are at the end of the rate-rising cycle, Carpenzano says.
f you consider that the yield of US investment grade corporate credit moved from around 1.5 to 2 per cent in 2021, to 6 per cent now, that is a big move. But also, the speed of movement was brutal
“The question today is not whether there will be a reacceleration of inflation, which is very unlikely,” he says. “Rather, the question is if inflation will hit the central banks’ target of 2 per cent, or if it will stabilise at around 3 per cent.”
Although the Federal Reserve has left the door open for a further increase in interest rates in September, it is unlikely we will see another period of rapid and large rate rises similar to the one in 2022.
“The fact that we are at the end of the hiking cycle makes a very compelling case for fixed income, and particularly for US investment grade corporate credit,” Carpenzano says.
Yet, he also calls for a cautious approach to investing in US investment grade corporate credit, because the risk of a recession is still there.
Although default rates are nearly negligible in investment grade credit, investors do need to look out for so-called “fallen angels”, companies that have their creditworthiness downgraded rapidly.
“The main risk of investment grade is not default, but spread volatility, which can be driven by downgrades to high yield. And so that’s why it’s important to monitor for and avoid fallen angels,” he says.
Sectors of Interest
One sector of US investment grade corporate credit that Capital Group is underweight is US energy and midstream, Carpenzano says. This is because despite the record profits these companies achieved last year when the oil price rose on the back of the Ukraine invasion, they didn’t take the opportunity provided by those high profits to de-lever their businesses.
Instead, many US energy companies used the high profits to lever up again or pay high dividends to shareholders.
“They didn’t use these high profits to de-lever and that’s our main concern, because now these companies are entering into a part of the cycle where profitability is going to be lower,” he says.
“Oil prices are going to be lower in the event of a slowdown or a recession, and yet US energy companies will start with a high level of debt. And so, as a result, you might start to see more downgrades in this sector and the valuation in terms of spread doesn’t compensate for this risk,” he says.
Carpenzano is more positive about selected companies in the technology sector, especially companies that derive their revenues from cloud computing services, because of their sticky income. Many cloud providers use a subscription model, which means steady inflows.
He also likes the US banking sector, despite the recent crisis among the smaller, regional banks in the country.
“The US banking sector still has very strong fundamentals, which is the result of the de-leveraging of the banking sector in the US and Europe after the global financial crisis,” he says. “These banks were forced by regulations to increase capital by a lot, and you can see the positive impact of that.”
“We focus more on the large, very well-recapitalised banks in the US, where spreads and valuations are still quite attractive. We think these banks will be able to navigate a recession.”
This article is sponsored by Capital Group. As such, the sponsor may suggest topics for consideration, but the Investment Innovation Institute [i3] will have final control over the content.
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.