By the end of October, the volatility in underlying government bond yields made strong returns appear unlikely for investment-grade markets. But in November, US investment-grade bonds delivered their biggest positive monthly total return since 1982. Spreads tightened and Treasury yields fell on a growing consensus that the Federal Reserve (Fed) had paused its rate-hiking efforts.

November was also the third-biggest month for easing in global financial conditions since 2008. As Chart 1 and 2 show, credit spreads have tightened, bar a brief but marked wobble in March around regional US bank issues and the collapse of Credit Suisse. Using global one-to-three-year investment-grade spreads over Treasuries, we are back to within seven basis points (bps) of the 10-year average level of 90bps.

Source: abrdn, Bank of America Merrill Lynch indices, January 2024.

Previous cycles are useful indicators

We think markets are behaving exactly as history dictates. If interest rates peaked in late July 2023, then past cycles indicate that investment-grade bonds would likely yield strong positive returns over the following 12 months. History also tells us that, within the same timeframe, credit spreads tend to be stable-to-tighter, as this usually occurs prior to the onset of a recession. Since late July, short-dated US investment-grade markets have returned 3.5% (as of 16 January 2024) and spreads over Treasuries have tightened by 8bps (8%). With corporate spreads at historical averages, are credit markets becoming increasingly complacent?

Scenario 1: a ‘soft landing’ for credit markets

We see three potential scenarios for credit markets. The first is most aligned with current market expectations: a ‘soft landing’. We’d need a predictable slowdown in inflation and growth for this to play out. Pre-emptive central banks would also have to ease interest rates as the cycle progresses to accommodate the ‘soft-landing’ process. If this is achieved, we expect further good total returns for investment-grade and high-yield markets.

Investing in a short-dated credit strategy should yield positive results in this environment. Yields will fall more at the short end of the curve as interest rate cuts begin and credit spreads remain range-bound or grind tighter. A strong starting yield means returns should be attractive.

A note of caution: apart from 1995, central banks have rarely achieved a ‘soft landing’. The current robust demand for credit could lead to further short-term spread tightening. Spreads will start to look ‘rich’ at this point.

Scenario 2: is a ‘hard landing’ likely?

The second scenario is a ‘hard landing’ – a recession where growth slows much faster than a ‘soft landing’.

With this outcome, the next question is always: what type of recession, or depth of recession, is likely? We can’t rule out a US recession this year, although any potential slowdown should be mild. On balance, we think developed-market corporates are well-placed to weather this outcome. We expect a fairly low default cycle, which should protect returns to some extent. While not our base case, a deeper recession could lead to a more pronounced default cycle, affecting high-yield market returns.

Most spread relationships are moving below their long-term averages, including between BB-rated high-yield bonds and BBB-rated investment-grade bonds. However, the lowest-rated CCC category buck this trend (see Chart 3). This shows that while the market is currently trying to price in a ‘soft landing’, the threat of a US recession means risk and caution remain in certain areas. 

Source: abrdn, Bank of America Merrill Lynch indices, December 2023.

In every recession, investment-grade spreads move comfortably north of 200bps over Treasuries. Today, demand for credit is structurally higher than ever, driven by pension funds and aided by other investors returning to the asset class due to the attractive all-in yield. Spread widening might therefore be more contained than in the past. However, spreads of under 100bps in early January give one pause.

Central banks will aggressively reduce interest rates in this environment, with the Fed cutting by at least 250bps. This will largely insulate the widening in short-dated credit spreads. And, with a mid-single-digit starting yield, investors should achieve a positive return. This would be an attractive outcome against most asset classes.

Scenario 3: higher-for-longer?

The final scenario is ‘higher-for-longer'. That’s when central banks maintain interest rates at elevated levels for longer than the market expects. This is the least likely scenario. However, we can’t rule it out if inflation remains sticky and there is no noticeable slowing in the US labour market. The correlation between Treasury yields and real yields with risk assets, including credit spreads, remains high. Therefore, in the latest moves, falling yields lead to increased demand for credit and spread tightening. A ‘higher-for-longer’ scenario would necessitate a rise in yields and a widening in credit spreads, although not to the extent we would expect in a recession.

The sting in the tail with this scenario is that the odds of a recession further out increase, as do the chances of an even deeper recession. While investment-grade issuers will be able to navigate the maturity wall coming in 2025, the high-yield market will struggle if yields are moving higher again.

This is a tough outcome for fixed income in general. That said, for short-dated credit strategies to eliminate the advantage of the starting yield and produce flat returns, all-in yields would need to increase by more than 275 basis points over a 12-month period. This seems highly improbable.  

Balancing risk and opportunity 

In the event of a ‘soft-landing’, exposure to longer-duration credit should yield a better outcome than investing in a short-dated credit strategy.  However, the latter should perform better in scenarios 2 and 3. Given current attractive starting yields, we believe short-dated credit offers a compelling opportunity on any risk-adjusted basis over the next year. Finally, we believe a global, active approach should help investors find more attractive credit spreads with little to no increase in risk. This should further enhance the potential for already good returns in 2024.