Comparing the difference in spreads at various maturities is a good way to assess valuations across the yield curve. Analyzing 10- and 30-year yield curves (the 30-year spread minus the 10-year spread) is the most common way to gauge long-end valuations relative to intermediate bonds. Curves are typically upward sloping, as bondholders are compensated with more spread when taking on extra duration risk (the sensitivity to interest rate moves).
In January, 10- and 30-year yield curves reached their flattest point in more than a decade, as 30-year spreads continued to outperform 10-year spreads.
Why has long-dollar credit done well?
Long-end bonds account for 28% of the USD IG index on a market value basis and 55% on a contribution to duration basis. In terms of sector composition, the long end has a lower mix of debt from the financials sector (16% of the long corporate index compared to 38% of the intermediate corporate index) (Chart 1). The underperformance of financials versus non-financials over the last two years has helped the long end.
Chart 1. Long corporate sector composition
Source: Bloomberg, February 2024.
Rising interest rates have been a catalyst for curve flattening and sharp changes in index characteristics. The average price of long bonds has fallen from the 10-year average of $112 and the 2020 high of $130 to today's $85. The average duration has fallen from a peak of 15.5 years to 12.8 years (Chart 2).
Chart 2. Long corporate index duration – 10-year period
Source: Bloomberg, February 2024.
Lower dollar prices and shorter durations support tighter spreads, with the long end most sensitive due to higher durations (Chart 3).
Chart 3. Long corporate index dollar price – 10-year period
Source: Bloomberg, February 2024.
The combination of increased demand from a range of sources and less supply at these higher yields also contributed to the good performance of long credit during 2023.
All-in yields have improved for USD IG credit. This has attracted both overseas and traditional domestic buyers of USD IG credit (insurance companies, pension plans, and retail investors).
International, insurance, and pension buyers typically purchase at the long end of dollar credit. For overseas investors, the all-in yields of the USD IG market, after hedging costs, are expensive versus alternatives in some currencies, such as the Japanese yen market. However, we believe these other markets do not offer the same liquidity and depth as the USD IG market.
With the recent increase in interest rates and stock market rallies, pension plans are fully funded. Many can now reduce risk by selling equities and buying fixed income to match pension obligations. (Chart 4).
Chart 4. The corporate pension funding ratio has come down over the last two months but remains above 100%
Source: J.P. Morgan, Milliman, February 2024.
In terms of supply, the issuance of long-dollar credit underwhelmed during 2023. Ten-year-plus issuance was 15% of total USD IG issuance, the lowest share since 2011. Higher yields have discouraged corporate treasurers from issuing long-dollar credit and locking in funding costs at higher rates for the long term. A drop in merger & acquisition (M&A) funding, which is typically longer maturity, has also contributed to the fall in 10-year-plus issuance.
Final thoughts
While we believe the technical picture for long-dollar credit currently looks strong, we remain cautious. We haven’t seen valuations this tight versus the rest of the curve since 2011. We expect an increase in long-end issuance as non-financial companies report fourth-quarter earnings and return to market with debt maturing, to refinance or fund M&A activity.
We’re currently underweight the long end of the credit curve. That said, there will be opportunities to increase our exposure, especially in credits that are improving and companies embarking on significant M&A activity. These companies are likely to quickly reduce their debt levels. Additionally, we see potential in long-term bonds with low coupons and low prices, particularly after they experience a narrowing of the gap compared to higher coupon and higher price bonds.
This narrowing gap is partly due to the National Association of Insurance Commissioners' elimination of the interest maintenance reserve floor until 2025. This allows insurance companies to recognize losses on fixed-income instruments without facing capital penalties. The change has resulted in the bulk selling of long-end bonds with low coupons and low prices, leading to more attractive valuations to higher-priced comparable corporate bonds (Chart 5).
Chart 5. Long-end valuations trading at very tight levels vs. intermediate bonds
Source: Bloomberg, February 2024.
Important information
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
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