Can Corporate Bonds Deliver in a Slowing Economy?

Our outlook for corporate bond investors generally remains favorable … but not without challenges. We believe yields are historically attractive, and corporate fundamentals largely appear sound. However, valuations are tight, and the supportive economic backdrop will likely change.

We expect consumers — whose spending strength propped up the economy in 2023 — to face mounting challenges in 2024, contributing to an economic slowdown. Our analysis of corporate fundamentals, market technical factors and bond valuations indicates that potentially attractive investment opportunities still exist, but diligent security selection is essential.

Corporate Fundamentals Remain Encouraging

Elevated inflation, rising interest rates and ongoing economic uncertainty forced many companies to scrutinize and shore up their finances in 2023. Accordingly, we believe corporate fundamentals (profitability, debt levels, expenses, etc.) generally appear healthy for investment-grade bond issuers and encouraging for bond investors.

• Spending is down. In general, persistent inflationary pressures have caused companies to reduce their capital spending. As a result, corporate earnings haven’t fallen as dramatically as expected. But it’s important to note that as companies refinance debt, higher interest rate costs will gradually work into their expense structures.

• Pricing power intact. Unlike previous periods of rising inflation, many corporations have been able to maintain their pricing power in this current episode of increasing prices. For some companies, notably those in the food and beverage industries, this pricing power has even aided results. Consumer savings accumulated during the COVID-19 era and steady wage gains helped households tackle higher prices, particularly for staple items.

• Debt growth is low. In the post-pandemic environment, corporate managements generally have maintained a more conservative approach toward debt. Our research indicates that most companies have only modestly increased their outstanding debt levels. Higher financing costs should keep this trend in place and support the broad investment-grade bond market.

• Leverage is manageable. With profit margins and earnings modestly lower and debt slightly higher, corporate leverage has ticked up. However, in our view, the overall trend is manageable and mostly confined to higher-rated companies.

Fundamentals also remain largely encouraging within the high-yield corporate bond market. As we would expect in the later stage of an economic cycle, profitability margins have been slowing. However, on a positive note, leverage has stayed below longer-term averages.

Technical Influences Are Mixed

While the overall business environment is generally favorable, the technical backdrop is somewhat uncertain. Some influences, including supply/demand and yield levels, appear broadly positive.

However, an uptick in default rates and tight spread levels may work against those positive factors. Furthermore, banks continued to tighten lending standards for all types of consumer and business loans in late 2023, highlighting additional market concerns for 2024.

A Favorable Supply and Demand Dynamic Persists

Following record new issuance to start the year, forecasts show year-over-year investment-grade corporate bond issuance should slow in 2024. Corporations issued $1.9 trillion in investment-grade debt in 2023, and observers peg the 2024 volume at $1.3 trillion.¹ Figure 1 shows the market’s issuance trends since 2010.

Amid continued demand for corporate bonds, we expect weaker supply in 2024 to bode well for the market. We continue to see evidence of strong investor demand for bonds at the current higher yield levels. We think this partly explains why credit spreads have remained at historically tight levels despite the heightened recessionary risks prevalent in 2023.

Defaults Remain Low but Are Rising

The high-yield default rate provides important insight into the health of the bond market and the economy. According to Fitch Ratings, U.S. corporate high-yield defaults rose to 2.99% in 2023 from 1.35% in 2022. Fitch expects the default rate to rise to a range of 5% to 5.5% in 2024, alongside higher interest rates and a slowing economy.

Despite last year’s increase and the forecasted rise for 2024, the default rate remains low compared with periods of financial stress. For example, at the height of the 2008 financial crisis, the high-yield default rate topped 20%. And during the pandemic, defaults climbed to 7.4% in November 2020.²

A Wall of Worry?

A pending “maturity wall” represents a looming threat to the high-yield bond market, as Figure 2 highlights. In 2024, $99 billion in high-yield bonds will mature, with another $217 billion, $368 billion and $341 billion maturing in 2025, 2026 and 2027, respectively. In the investment-grade market, $9.5 trillion is set to mature through 2027.³

This maturing debt represents bonds issued during the ultra-low interest rate environment in place before the Federal Reserve (Fed) started aggressively raising rates in 2022. Accordingly, companies seeking to refinance their debt face a much higher interest rate environment today.

Companies with higher leverage may struggle to afford the higher financing costs. However, some firms will be able to reduce their interest-rate costs by refinancing floating-rate debt with lower-cost fixed-rate debt. This partly reflects the higher costs of shorter-term funding, which rose due to Fed rate hikes and the inverted Treasury yield curve.

An Unusual Spread Backdrop

Credit spreads typically widen when the Fed raises interest rates. Investors worry that the Fed’s rate hikes will ultimately provoke a recession.

But in the latest Fed rate-hike cycle, credit spreads bucked historical trends and narrowed, which contributed to last year’s strong performance from corporate bonds. Factors that aren’t typical of rate-hike cycles, including a still-robust economy, strong consumer spending and durable corporate fundamentals, helped drive spreads tighter.

Additionally, quality spreads have also remained unusually tight, hovering at the low end of their longer-term averages. In this environment of credit and quality spreads lingering near multiyear tight levels, investors have little incentive to take on additional risk. However, as the economy slows, we believe spreads will move wider, and more attractive buying opportunities should emerge.

Valuations Highlight the Importance of Selectivity

After strong performance and tighter credit spreads in 2023, compelling valuations in the corporate bond market aren't readily apparent. Recently, certain investment-grade companies in the banking, automotive and energy sectors have been trading at attractive levels, in our view. But staying selective is crucial.

Within the high-yield segment, the energy sector has benefited from a positive mergers-and-acquisitions cycle. And we've identified "rising star" candidates (high-yield bonds facing potential credit-rating upgrades to investment-grade status) in the gaming and building materials sectors. Again, scrutiny is key, particularly in the higher-risk sectors, such as the retail and commodity-related industries.

We also believe focusing on securities with intermediate-duration profiles is prudent in today’s market. In our view, these bonds deliver most of the return potential of longer-duration securities with less volatility.