Does the US investment-grade credit market, in bear territory for nearly two years, finally offer more reward than risk of a larger default cycle?
US investment-grade credit has been in a bear market since July 2014, one that has lasted longer than six such sell-offs since 1925. With spreads now wider than, or close to, levels seen in 12-of-15 past US recessions, moderating issuance, and markets pricing a less-than-quarter-percentage-point interest-rate move by the Federal Reserve this year, our view is that the rewards of this market outweigh the risks from a larger default cycle.
One particularly promising segment, according to our colleague Adam Richmond, who recently initiated coverage of the US investment-grade credit market, is long-dated (10-year+) bonds, which hold an average rating of A- and average duration of 13 years and currently yield 5.1%. From my perspective, this segment also looks attractive relative to broader cross-asset pricing and our macro views.
For some investors, 5.1% may not seem like obvious value for long-dated bonds that will never earn more than the original coupon and principal. Yet, this view of value closely aligns with several of the market’s most basic macro questions: How high is potential growth? What’s the long-run path of inflation? How much can equities return at current valuations? Will demographics matter for investor demand? How bad could the default cycle get?
Debating the value of long-dated investment-grade credit needs to start with expectations for how low inflation will stay long term. The market for Treasury Inflation Protected Securities implies that US consumer product inflation will average just 1.6% a year over the next 30 years—near an all-time low—and expectations are similarly extreme compared to history in Europe. Our inflation strategists believe this pricing is excessive. For this moment, however, it is where the market clears. This means that the 5.1% on investment-grade corporate bonds, relative to market pricing, offers a real yield of around 3.5%.
How much of this real yield gets eroded if the US credit market goes through a rough default cycle? To estimate this, our credit strategy team crunched data from Moody’s going back to the 1970s and concluded that a portfolio with ratings similar to today’s market would have lost, on average, 22 basis points, or hundredths of a percentage point, per year over a 10-year holding period. The worst cohort lost 48 basis points. Assuming the latter, the real yield on investment-grade credit would still sit at 3.0%.
Is this attractive? Our US economists believe that long-run trend growth in the US may now be no more than 1.5% a year. Our European economists believe that eurozone trend growth is no better than 1.0% a year. If these macro estimates are in the ballpark, a 3.0% long-run, loss-adjusted real yield looks attractive, in our view.
What about stocks? Our long-run return model for the S&P 500, a benchmark for the broader market, currently estimates a 4.4% annualized real return over the next decade, for a market that has averaged around 15.2% volatility over the past 30 years. Long-end investment-grade corporate bonds could have a real yield of 3.0% for 8.5% historical volatility. This is surprisingly competitive, especially in a world where aging populations create a strong demand for income, but less tolerance for volatility.
Receiving just 5% for such long-dated bonds may not seem like much, especially for a market that offered much higher returns for most of our investing lifetimes. However, we must judge this yield in light of the world as it is and will be, not what it once was.
If you don’t believe 5% is a fair level for long-dated corporate bonds, it suggests that your assumptions about inflation, potential growth, equity returns and credit losses are very different from what the market is currently pricing—or what our models are forecasting.
It’s something to ponder.