Fixed income duration made a round trip in 2023, adding to returns at the beginning of the year, detracting during the summer months, and significantly boosting returns toward year end. But one fairly consistent return driver over the past several months has been spread compression – a smaller difference in yield between securities of a given credit quality and Treasuries with the same maturity. The top-returning fixed income categories in 2023 (bank loans, high yield, and emerging markets) all posted double-digit returns, thanks in large part, to falling spreads in those markets. And on the investment grade side, corporate bonds outpaced both Treasuries and cash due to IG spreads compressing.

How tight can they get?
In January 2024, IG corporate spreads fell below 1% for the first time in nearly two years. With spreads this low, some might fear that the potential for a hard landing isn’t priced in at all. Perhaps holding even a balanced view of hard landing/soft landing would make you want to take some chips off the table if you’ve added to risk last year, or wait for a better entry point if you haven’t.

Before the sizable rally in rates to end the year, we made the point that many companies could be hesitant to issue debt in such a high-yielding environment. Constrained supply leads to excess demand, and excess demand for corporate bonds can push spreads lower than credit fundamentals would suggest. In other words, spreads near 1% shouldn’t necessarily be viewed skeptically as the bond market whistling past the graveyard. They could represent a more balanced view of probabilistic outcomes that now started to skew toward the soft landing, with supply/demand dynamics driving spreads down from median levels to 1st quartile levels. So perhaps there is still room for additional spread compression, from some combination of the soft landing priced in even more strongly, and/or continued favorable supply/demand dynamics.

If IG corporate spreads stay rangebound, you still get a return advantage over Treasuries of about 1% over the course of the entire year. But, on top of that, how much upside is still left? Could we see investment grade spreads fall to post-Global Financial Crisis tights of 80 bps? Achieving that level would suggest that corporate bonds outperform Treasuries by 1%, on top of any yield advantage. All-time tights of 51 bps? Now we’re talking about 2-3% outperformance above the yield advantage. The strong returns over the past few months have made both of these scenarios a bit less exciting than they once were. No one should be losing too much sleep over possibly missing out on a surprise 2-3% return in their bond portfolio, in an environment that would undoubtedly be favorable to equity markets as well.

Higher issuance on the horizon?
Plus, now that we’ve gone through a bit of a reset, with rates falling so much in November and December, we might be due for a reversal in issuance patterns. January appears to have been a lot busier for new corporate debt. Companies who were patient throughout 2H 2023 might have found a window of opportunity to raise capital at acceptable interest expense. Continued issuance momentum can put upward pressure on spreads. And, of course, you still have the growth scare/hard landing scenario, where negative price action from spread widening easily wipes away any yield advantage. Growth has been resilient and the market keeps pushing out any hard landing or recession fears. But the lower starting point means the upside/downside tradeoff has become a bit more asymmetric.

Plan ahead for tighter spreads
So if you’re less confident in taking on significant credit risk at these levels of spreads, consider active management over passive. We think the value proposition is significantly more attractive. Across fixed income, we’re seeing divergence in returns… between higher-rated credit and lower-rated credits, newly issued mortgages vs. older mortgages, short duration Treasuries vs. long duration Treasuries, and so on. A tighter spread environment requires being more selective. Perhaps it doesn’t make as much sense to own everything under the sun that certain passive approaches provide. Active strategies can enhance yield while avoiding securities with asymmetric payoff profiles. And, of course, quickly deploy dry powder if and when there is a better entry point for spreads.

For the cautious investor worried about the next shoe to drop, an allocation in active, high-quality bonds can represent insurance for getting the soft landing call wrong. For the optimistic investor, the more selective approach can help play a bit more defense now and offense later. A little something for everyone.
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