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For Professional Clients and, in Switzerland, for Qualified Investors only. In Israel for Sophisticated Investors only.
English
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IDEAS AND KNOWLEDGE TO INSPIRE YOUR INVESTMENTS THINKING
16 July 2020

Is investment grade nearing the danger zone?

Global investment-grade credit spreads have largely recovered from the Covid-19 pandemic-induced widening though the leisure sector has, unsurprisingly, yet to see spreads narrow.

 

Markets are now faced with broadly declining spreads and yields, along with a lengthening duration. Contemplating the potential risks and returns ahead brings us to the conclusion that returning credit markets to Earth after the extraordinary global economic shock (akin to wartime) and monetary and fiscal response to the pandemic will be like trying to land a fighter jet on an aircraft carrier in a storm. While it can be done, it requires great skill and is very hazardous. And although take-off from a carrier is tricky enough, landing is even more difficult.

 

While a smooth economic recovery and soft landing for the investment-grade bond sector is entirely possible, we see two fat tail risks, which turn it into a bumpy one at best.

 

In scenario one, more severe and lasting economic damage could lead to more credit-rating downgrades and defaults, necessitating wider credit spreads (leading to lower corporate- bond prices).

 

In scenario two, we could see a more vigorous recovery, leading to inflation and a need to unwind the extraordinary global monetary and fiscal stimulus much faster. This will in turn lead to higher government and corporate-bond yields (and hence lower prices for high-quality bonds).

 

The three principal risks attached to investment-grade corporate bonds are credit risk, duration and illiquidity (relative to government bonds, equities or foreign-exchange markets, for example).

 

Of course, high yield carries more credit risk and is even less liquid, but those bonds tend to be shorter duration, not as interest-rate sensitive, while inflation is less of an enemy for them. Government bonds typically have longer duration (and lower coupons, and are less able to cushion against capital-price falls), but they have no or less credit risk and are far more liquid. So, while investment grade would probably not be the worst-performing bond type in either of the tail-risk scenarios described above, it could still perform poorly in absolute terms in either scenario.

 

Howard Cunningham, portfolio manager, Newton Investment Management.

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Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.

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