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NAVIGATING OPPORTUNITIES IN INVESTMENT GRADE CREDIT
NAVIGATING FIXED INCOME
March 1, 2023 | 9 Minute Read
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We believe the deep and diverse universe of investment grade (IG) corporate
bonds can provide investors with a stable source of income to achieve investment
goals over various time horizons. At the same time, the asset class provides
exposure to typically well-established companies, some of which are helping to
drive the digital revolution, energy transition and inclusive growth.
--------------------------------------------------------------------------------
THE CASE FOR IG CREDIT
A HIGH-QUALITY SOURCE OF INCOME
The US and European IG credit markets provide a healthy yield of 5.4% and 4.1%,
respectively.1 We believe this is an attractive source of predictable income
that can help investors achieve medium- to long-term investment goals (Exhibit
1).
EXHIBIT 1: INCOME AND TOTAL RETURN POTENTIAL IS THE MOST ATTRACTIVE IT HAS BEEN
IN MORE THAN A DECADE
Source: Macrobond, ICE BoFAML. As of February 16, 2023. Pre-pandemic average
reflects 2009-2019.
CAPITAL PRESERVATION IN AN AGE OF UNCERTAINTY
Investing in IG credit involves lending to resilient and often well-established
companies that typically honor coupon and principal payments. In other words,
the potential for capital loss or defaults owing to credit risk is low. And
though the asset class is sensitive to duration risk, we believe its high
quality is important in an age of uncertainty, and as investors face inflection
points including a shifting economic landscape, new geopolitical alliances,
accelerations in the adoption of new technologies, and the energy transition.
A DEEP AND DIVERSE INVESTMENT OPPORTUNITY SET
There are over $12 trillion worth of corporate bonds in the global IG credit
universe comprised of bond issuers from 59 countries.2 This diverse geographical
footprint means investors can capture outright and relative investment
opportunities across regions. The investment opportunity set is also
characterized by various bond maturities, allowing investors to achieve
investment goals over various time horizons (Exhibit 2). Further, the broad
spectrum of bonds available in the asset class enables investors to position
along the credit curve depending on the interest rate outlook. For example,
recession fears have led to inverted credit curves. As a result, short- and
intermediate-maturity bonds exhibit a more attractive carry-and-roll profile
relative to longer-dated bonds.
EXHIBIT 2: INVESTORS CAN GAIN BROAD GEOGRAPHICAL EXPOSURE AND MOVE UP AND DOWN
THE MATURITY LADDER
Source: Bloomberg Global Aggregate Corporate Index. As of February 15, 2023. For
illustrative purposes only.
WHY NOW?
TOTAL RETURN POTENTIAL IS AT A DECADE HIGH
When yields were low—or even negative—high quality bond yields faced constraints
from effective lower bounds during risk-off episodes. But after a painful
adjustment to higher yields in 2022,3 IG credit now offers the most attractive
level of income in more than a decade. In fact, total return potential is at the
high end of its historical range, especially by the standards of the post-global
financial crisis period. This higher yield—or income—can offer shelter during
risk-off moves but also help to offset declines in bond prices should rates rise
further. A slower pace of monetary tightening also implies lower rate volatility
which is further supportive of “low beta” pockets of fixed income markets like
IG credit.
Macro resilience, firm credit fundamentals and supportive technicals have
already helped IG credit deliver decent positive total returns year-to-date
(Exhibit 3). As a result, we now consider IG credit spreads to be consistent
with a fair level of carry and roll,4 a component of excess returns which tends
to dominate over time.
EXHIBIT 3: THE TIDE ON TOTAL RETURNS IS ALREADY TURNING
Source: Macrobond, based on ICE BoFAML indexes. As of February 17, 2023.
RESILIENCE TO DOWNSIDE GROWTH RISKS
Except for the UK, most major economies look set to avoid recessions in 2023.
But even if recessions are avoided, growth will likely remain below trend and
earnings growth among corporates is decelerating. Against this backdrop, we
would expect IG corporate bond issuers—whose credit fundamentals remain
healthy—to prove more resilient relative to more cyclical assets like equities,
in line with the historical trend (Exhibit 4).
Momentum in credit rating actions has been positive for almost two years, with
the notional amount of rising star bonds (upgrades from high yield) in the US
market outpacing fallen angels (downgrades into high yield) for eight
consecutive quarters.5 Even as balance sheet liquidity positions normalize
towards pre-pandemic levels, we expect fallen angel activity to remain contained
under most economic scenarios, including a hard landing. This is due to the
strong starting point of balance sheet positions and compressed timeline of the
current cycle which has—in many cases—kept late-cycle behaviors that can lead to
a deterioration in credit quality at bay. As a result, the attractive yield
delivered by the asset class largely stems from high quality issuers and is not
being skewed higher by weaker credits on the verge of downgrade into the high
yield market.
Furthermore, the sector composition of IG credit indexes tends to be tilted
towards defensive sectors like energy, defense, consumer staples and
high-quality financials, further diminishing sensitivity to downside growth
risks. Taken together, firm credit fundamentals and low cyclicality relative to
other assets suggests limited spread widening in 2023—particularly in relation
to prior growth downturns—as credit concerns remain in check.
EXHIBIT 4: IG CREDIT TENDS TO EXHIBIT RESILIENCE DURING EQUITY MARKET DRAWDOWNS
Source: Goldman Sachs Asset Management, based on Bloomberg indexes.
SUPPORTIVE TECHNICAL DYNAMICS
With most companies tapping capital markets to raise debt while interest rates
were low, near-term refinancing needs are limited. For example, only around 16%
of US IG corporate bonds mature in 2023 and 2024.6 A subdued new supply outlook
combined with robust demand from yield-oriented investors paints a positive
technical picture for the asset class. Demand for IG credit started to trend
upwards at the end of 2022 as investors began to rotate back up the quality
spectrum. Inflows into the asset class have maintained positive momentum into
2023 (Exhibit 5) and still-light positioning relative to pre-COVID levels
suggests demand may rise further, prolonging the positive technical impulse for
performance.
EXHIBIT 5: INVESTORS REGAIN APPETITE FOR HIGH QUALITY FIXED INCOME ASSETS AMID
HIGHER YIELDS
Source: Morningstar, Goldman Sachs Asset Management. As of January 2023.
WHERE ARE THE OPPORTUNITIES?
In the absence of ever-lower interest rates and in the presence of greater macro
uncertainty we expect active bond selection alongside dynamic sector allocation
to be an increasingly important driver of alpha generation (Box 1). Below we
highlight three high-conviction investment views:
RELATIVE VALUE: LOWER QUALITY BONDS WITHIN A HIGHER QUALITY ASSET CLASS
The BBB-rated part of the IG credit market is the lowest quality but largest and
most diverse rating cohort. In our view, this deep investment opportunity set
provides attractive income for solid fundamentals. Notably, BBB-rated issuers
appear to be managing capital conservatively, and have maintained some cash flow
after capital spending, dividend payments and share buybacks.
SECTOR SPOTLIGHT: BANKING ON BANKS
In 2022, excess savings deposits coupled with an increase in loan growth
required banks to raise capital in line with regulatory requirements. The
resultant increase in new bond supply saw corporate bonds issued by banks
accumulate more spread premium relative to other sectors. In our view, spreads
appear wide relative to resilient credit fundamentals; the banking sector is
well capitalized, while robust lending standards and healthy private sector
balance sheets implies loan books are in good shape. Further, many banks have
built-up provisions in event of losses on loans. In addition, higher rates point
to an improved outlook for net interest margins. The sector is also
geographically diverse and can cater to various investor appetites, with
investors able to gain access to the various parts of a bank’s capital
structure. Overall, attractive valuations—as reflected by wide spreads—combined
with strong fundamentals leads us to be overweight the bank sector.
THEMATIC LENS: TELECOMS – INTERNET EXPLORER
The internet has become an essential tool for powering the global economy, with
lockdowns turbocharging demand for video conferencing and telemedicine alongside
online gaming, education, and learning. As providers of high-speed internet,
companies in the telecommunications (telecoms) sector are at the center of the
digital revolution. High investment needs lead to high debt issuance within the
sector, and in recent years, debt-funded M&A activity has placed many companies
in the BBB-rating cohort. We seek to select bonds issued by companies with
robust credit fundamentals that are well positioned for the industry’s
crosscurrents. For example, in the past, we favored cable companies that
delivered internet access through dial-up modem, as this reflected an
improvement on phone line links provided by telecoms. However, today, we see
greater investment potential in telecoms that are providing broadband internet
via wireless fiber networks and 5G based wireless products.
Fiber is arguably the leading technology currently capable of delivering the
speed and capacity of internet required by households, businesses, and
governments. It is also considered an energy-efficient solution to growth in
internet traffic as more usage shifts towards mobile devices. According to
company data and industry reports, Fiber is 80% more energy efficiency than
copper networks used by cable providers, making it a key solution for helping
the telecom sector grow while reducing its carbon footprint (Exhibit 6). Indeed,
the use of proceeds for a recent green bond issued in the sector are intended
for fiber expansion.
Some Telecom companies offer basic broadband internet access through Fixed
Wireless Access (FWA), taking advantage of existing wireless spectrum holdings
as opposed to a physical connection to the premises. This offering’s internet
speed is not as fast as fiber or cable, though it can be more cost-effective.
This price competition is leading incumbents to expand internet coverage in
rural areas and disadvantaged areas, which we believe can help to narrow digital
divides and advance inclusive growth. Looking ahead, we suspect the sector may
encounter further disruption as new competitive technologies emerge and as the
policy backdrop evolves. We stand ready to refresh our internet explorer
investment tab accordingly.
EXHIBIT 6: MORE CONNECTED DEVICES, MORE INTERNET DEMAND
Source: Goldman Sachs Global Investment Research GS Sustain. As of August 16,
2022.
BOX 1: THE NEW ALPHA-BET
FROM GOLDILOCKS TO THE THREE BEARS
In the last cycle, a ‘Goldilocks’ regime of not too high or too low growth and
inflation allowed central banks to buffer—and elongate—the cycle. Indeed, the
last US expansion was one of the longest on record. Furthermore, a wave of
liquidity and a downtrend in interest rates helped to lift all assets, with
limited performance dispersion both across and within asset classes. For
example, corporate bonds in a particular sector generally performed in line with
each other despite differences in company-level balance sheet positions. In
2022, this setup was disrupted by high inflation and aggressive monetary
tightening. Going forward, even as inflation peaks and the pace of policy
tightening slows, we think investors will need to navigate three bearish
factors:
1. Higher inflation stemming from structural shifts such as de-globalization in
goods and labor, demographic aging, decarbonization, and destabilization in
geopolitics.
2. Tighter policy given firmer inflation and high government debt levels.
3. Growth volatility reflecting macro, political and policy uncertainty
alongside the risk of supply side shocks in tight commodity markets.
INVESTMENT IMPLICATIONS
In our view, this backdrop will give rise to a new investment “Alpha-Bet”
characterized by:
1. Greater bond-level dispersion that requires active security selection to
distinguish borrowers based on their ability to adapt to slower economic and
earnings growth, as well as a higher-for-longer inflation and rate
environment.
2. More risk premium stemming from left-tail risks driven by economic,
geopolitical and industry shifts which can give rise to tactical investment
opportunities.
3. Shorter cycles which require a dynamic approach to asset and sector
allocation.7
RELATED INSIGHTS
slide 1 to 2 of 3
* January 9, 2023 | Fixed Income Macro Views
NAVIGATING FIXED INCOME IN 2023
January 9, 2023 For investors, there has been no shortage of downpours in
recent years. The multiple headwinds have created a challenging investment
environment and an age of volatility. Stormy times can lead some investors to
step off the racetrack to look for shelter in cash. Others, however, are
adjusting to volatile conditions and stepping up—or considering—investments
in fixed income. Read More
* January 6, 2023 | Fixed Income Macro Views
NAVIGATING EXTERNAL EM DEBT
January 6, 2023 A tough macro backdrop caused by the pandemic, Russia’s
invasion of Ukraine and tighter global financial conditions has placed
pressure on emerging market (EM) sovereign borrowers in 2022. However,
excluding sovereigns in distress, EM sovereign bond spreads are broadly
unchanged year-to-date and have outperformed similar rated US corporate bond
spreads. We believe this reflects resilience in the broader market,
particularly among middle-income—and often larger—EM sovereigns. Read More
* January 3, 2023 | Quarterly Investment Outlook
BRING ON BONDS
January 3, 2023 Over the past couple of years, a confluence of factors—a
global pandemic, surging inflation, war in Europe, aggressive monetary
tightening and a cost-of-living crisis—has rocked the boat for investors like
never before. In 2023, we think some—but not all—of these headwinds will
begin to abate. Learn more in our Fixed Income 1Q 2023 Outlook: Bring On
Bonds where we discuss growth, inflation, monetary and fiscal policy, and
more. Read More
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1Source: Macrobond, ICE BoFAML. As of February 17, 2023.
2Based on the Bloomberg Global Aggregate Corporate Index as of February 21,
2023.
3The sharp rise in interest rates amid aggressive monetary tightening drove
majority of the negative total return in IG credit markets in 2022.
4Carry reflects the expected total return (net of financing costs) of an asset
beyond price appreciation. It is estimated by the yield differential (or
‘spread’) between a fixed income sector and a risk-free asset (typically a
relevant sovereign bond yield). Roll refers to a change in spread from “rolling
down” a credit curve over time.
5Source: Bloomberg, Goldman Sachs Global Investment Research. As of Q4 2022.
6Source: Goldman Sachs Global Investment Research 2023 Global Credit Outlook:
There will be yield as of November 16, 2022
7See Fixed Income Asset Allocation: A Well-Balanced Approach for more details.
Risk Considerations
Mortgage-related and other asset-backed securities are subject to
credit/default, interest rate and certain additional risks, including extension
risk (i.e., in periods of rising interest rates, issuers may pay principal later
than expected) and prepayment risk (i.e., in periods of declining interest
rates, issuers may pay principal more quickly than expected, causing the
strategy to reinvest proceeds at lower prevailing interest rates).
Collateralized loan obligations (“CLOs”) involve many of the risks associated
with debt securities, including interest rate risk, credit risk, default risk,
and liquidity risk. The risks of an investment in a CLO also depend largely on
the quality and type of the collateral and the class or “tranche” of the CLO.
There is the possibility that the strategy may invest in CLOs that are
subordinate to other classes. CLOs also can be difficult to value and may be
highly leveraged (which could make them highly volatile). The use of CLOs may
result in losses.
Emerging markets investments may be less liquid and are subject to greater risk
than developed market investments as a result of, but not limited to, the
following: inadequate regulations, volatile securities markets, adverse exchange
rates, and social, political, military, regulatory, economic or environmental
developments, or natural disasters.
Environmental, Social and Governance (“ESG”) strategies may take risks or
eliminate exposures found in other strategies or broad market benchmarks that
may cause performance to diverge from the performance of these other strategies
or market benchmarks. ESG strategies will be subject to the risks associated
with their underlying investments’ asset classes. Further, the demand within
certain markets or sectors that an ESG strategy targets may not develop as
forecasted or may develop more slowly than anticipated.
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Views and opinions are current as of February 24, 2023 and may be subject to
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Index Benchmarks
Indices are unmanaged. The figures for the index reflect the reinvestment of all
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or expenses which would reduce returns. Investors cannot invest directly in
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Manager believes, in part based on industry practice, provide a suitable
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index overstates the performance of hedge funds generally.
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Date of first use: March 1, 2023. 308467-OTU-1753214.
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