Credit Where It’s Due

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Since the Federal Reserve began raising interest rates in early 2022, investors have understandably focused a great deal on the appropriate duration positioning within fixed income portfolios. Even as we have arguably reached a point where we are close to seeing the end of the interest rate hiking cycle, questions about the right time to add duration continue to dominate our conversations with advisors.

However, it is important to remember the other sources of fixed income return. While duration has received most of the attention, the real performance story this year has been in credit. Despite continuing talk about recession fears, high yield option-adjusted spreads have tightened by almost 100 basis points since January 1, and the best performing fixed income asset classes this year are the ones that carry the most spread exposure.

High Yield and Bank Loans Are Top Performers This Year (1/1/23–8/22/23)

Source: Natixis Investment Managers Solutions

Lower Credit Quality, Higher Performance
While duration has remained a performance headwind so far this year, credit is the bigger differentiator – every major fixed income asset class with an average quality rating of BBB+ or lower has seen positive returns year-to-date. Only those asset classes with the combination of longer duration and higher quality have remained pressured.

Why has credit performed this year? While inflation remains a much-discussed risk, market-based inflation expectations are relatively flat on a year-to-date basis. The increase we have seen in yields has been driven by real yields, which are a reflection of growth expectations rather than inflation expectations.

Comparison of 10-Year Yields (5/1/23–8/15/23)

Source: Natixis Investment Managers Solutions; Bloomberg

Robust Economic Growth Supports Credit Valuations
Spreads have tightened as the market has come to appreciate the robustness of growth and is pricing in a lower likelihood of a credit event. This certainly makes sense given the strength of corporate balance sheets and the persistence of US consumer spending. Corporate interest coverage ratios remain near all-time highs, suggesting firms have ample cash to meet debt service obligations.

Consumer Spending Strength Persists
In addition, given that the US economy is roughly 70% consumption-based, the persistent strength of the US consumer provides another column of support for credit valuations. While consumer savings are not as high as they were coming out of the pandemic, the ratio of debt payments to disposable income remains near historical lows, suggesting that consumers can continue to spend unless we begin to see labor market weakness in the form of widespread job losses.

Financial Obligations Ratio: Household Debt Payments to Total Disposable Income

Source: Natixis Investment Managers Solutions; Bloomberg

While we believe there is a strong argument for extending duration in this environment, it’s important to remember the other potential sources of return in your fixed income allocation and maintain the appropriate balance given your investment objectives.