Investment-grade corporate bonds have had a bumpy start to the year, hit by the volatility of interest rate expectations.
High-yield bonds have fared better amid a generally ‘risk-on’ market. However, it is possible to see these roles reversing in the remainder of 2024, as default rates rise, hitting high yield, and interest rates start to come down, favouring investment grade.
Since the start of the year, the average fund in the Investment Association Sterling Corporate Bond grade sector, which tends to focus on investment-grade bonds, is down 1.30 per cent, while the average sterling high-yield fund is up 1.14 per cent.
In general, this reflects the higher interest rate sensitivity of investment-grade bonds, set against the higher credit risk for higher-yield bonds.
Nevertheless, there are signs that this might be changing. There are reports of growing demand for investment-grade bonds.
UK pension funds, for example, have been moving into UK corporate bonds in search of higher yields. This has encouraged some French and German companies, including German real estate company Vonovia and French luxury goods group Kering, to issue sterling debt for the first time.
FT Adviser's sister title the Financial Times reported that the share of European corporate bond sales denominated in sterling has risen to 8.4 per cent from 6.8 per cent a year ago. This suggests a better environment for investment-grade bonds looking forward.
A tougher outlook for default rates
At the same time, there is a tougher outlook for default rates. These have been benign, as the ability to borrow at low interest rates kept many companies afloat that might otherwise have struggled.
However, the latest report from Moody’s showed that in 2023 the annual corporate default total hit its highest level since the onset of the pandemic.
Non-financial defaults almost tripled to 92 in 2023 from 31 in 2022. The ratings agency expects the default rate to rise to 5.8 per cent in early 2024, from 5.6 per cent last year.
Spreads for both investment-grade and high-yield bonds – over government bonds – offer relatively little margin for error. They have narrowed further this year, in spite of tougher economic conditions.
They now sit at around the level last seen in mid-2021, before interest rates started to rise. In the past decade, they have only been this low on two occasions: 2018 and 2021.
However, this is likely to be a greater problem for high-yield bonds.
Kenny Watson, manager of the Liontrust Sustainable Future Monthly Income Bond fund, says investment-grade bonds should be relatively insulated: “Corporate fundamentals remain robust, with low levels of leverage, high interest coverage and ample liquidity.
"Though corporate fundamentals will inevitably weaken through a period of economic deterioration, the incredibly strong starting point means investment-grade companies are more than capable of withstanding a prolonged period of low growth.” However, higher-yield bonds may see more of an impact.
Equally, higher-yield bonds may be more vulnerable to refinancing risk. While many companies managed to secure long-term financing while interest rates were still low, there is still a refinancing risk for many companies that is likely to become more acute over time.
