Maturity positioning only tells half the story of fixed income with credit positioning comprising the other half. U.S. Treasuries are used to evaluate how changes in rates are impacting fixed income returns, as they are considered “risk-free.” This means there is (theoretically) no default risk. However, most fixed income allocations are not exclusively invested in U.S. Treasury bonds and allocations will often include an allocation to bonds from issuers that are not risk-free and have at least the possibility of default risk. These allocations include fixed income securities like corporate bonds, mortgage bonds, floating rate bonds, commercial mortgages, and asset-backed securities. While there is the potential for default in these investments, investors are compensated for this risk with a higher yield than what is available in similar maturity U.S. Treasuries. The higher yield compared to U.S. Treasuries is referred to as the “spread” of the bond and just as bond prices move in the opposite of interest rates, they also move in the opposite direction of spreads (i.e., when spreads increase, bond prices decrease).
As depicted, returns across these different fixed income assets range year-to-date from about -9% to over -14%. While duration has had an impact on these returns with the Bloomberg U.S. Corporate Index down the most due to the longest duration, the credit consideration has also impacted returns as the higher risk of recession has resulted in investors demanding more of a yield to compensate for this risk (i.e., a higher spread). The same can be said about U.S. Corporate High Yield index, which has a relatively low duration but is more sensitive to credit spreads as these companies are at higher risk of default, resulting in this index returning over -14% in the first half of 2022.
The outlook on credit has become more clouded in recent weeks as companies grapple with higher energy costs, higher input costs, and potentially waning consumer demand. At the same time, companies must evaluate how rising interest rates impact their balance sheets. The good news is that many companies have taken advantage of the low interest rate environment over the last year by taking out debt at very low rates (much like how consumers have refinanced their mortgages when rates were 3% or less). This has resulted in many companies locking in very low debt payments for many years to come. Investment grade issuers have the luxury of issuing (or taking out) debt that is repaid in 20 years or more. Issuers with below investment grade ratings generally are not afforded this luxury but they have still been able to refinance or issue debt over the past few years to be paid back in five or more years. This means that while the cost of issuing or refinancing debt has increased this year, the impact is relatively muted as companies previously locked in a significant portion of their debt at low rates. According to data compiled by Bloomberg, just 8% of all high yield debt outstanding will need to be paid back by the end of 2024, giving the majority of companies breathing room if there is a pending economic slowdown. To be fair, companies will still need to issue debt in the higher rate environment in order to continue to grow and expand, but this adjustment should be digestible for companies as absolute borrowing rates remain reasonable in the historical context and the need to refinance existing debt is limited.