Bonds have historically served as a diversifier against riskier asset classes such as equities and commodities. However, in 2022, this relationship broke down as both bonds and equities sold off substantially due to spiking inflation and subsequent rate hikes. Typically, as shown in the chart below, correlations between equities and bonds have historically been negative when inflation eases, allowing bonds to regain their diversification benefits. We’ve seen this dynamic return more recently. As central banks begin cutting rates and core inflation eases below 3%, the stock-bond correlations should move back to negative. And high-quality fixed income will once again assume its role as a portfolio diversifier.

At the start of August 2024, equities sold off due to weaker US labor market data and geopolitical risks, while high-quality fixed income investments, such as US government bonds and investment grade credit, delivered positive total returns as Treasury yields dropped.

Investment grade credit, with its duration exposure has a built-in diversifier. This means that although corporate spreads might widen in response to disappointing economic data or volatility, investment grade credit also benefits significantly from a drop in interest rates, which protects total returns.

If yields are now more attractive and high-quality fixed income is expected to be a better diversifier going forward, why not invest in government bonds like US Treasuries rather than investment grade credit, given that government bonds already offer an attractive yield? The answer lies in the long-term performance of investment grade credit. It’s not so much about timing the market as it is about time in the market. Over the long term, investment grade credit has delivered higher total returns than government bonds. For example, global investment grade credit has delivered an annual total return of 3.6% over the last 24 years (2000-2023)¹, compared to an average of 2.9% for global government bonds.² Over the last five years, global investment grade credit has outperformed global government bonds by an average 1% per year.

Our base case anticipates moderating global growth without a recession, ongoing disinflation, and a pivot by central banks to a less restrictive policy stance. This creates a supportive backdrop for high-quality fixed income in general, and investment grade credit in particular. In this scenario, investors can enjoy both an attractive yield and yield pick-up over government bonds, and perhaps also benefit from further compression of credit spreads. If we are wrong and encounter much weaker growth or a recession, leading to some credit spread widening, a likely more aggressive response from central banks would lead to a rally in government bonds, protecting total returns on investment grade credits.

Technicals are also favorable, as the demand for credit remains strong with investors looking to lock in higher yields. Barring a major shock, there is little reason to think credit spreads should widen meaningfully from here. Corporate fundamentals for investment grade companies are very solid. The recent hiking cycle by central banks has not inflicted pain like previous cycles, as investment grade corporates were proactive in managing their debt levels and issuing debt at low yields during the low-rate environment of the Covid pandemic. Therefore, interest rate costs for investment grade companies are manageable.

Lastly, we expect increased dispersion in credit markets, which is good news for active and skilled credit managers. By focusing on high-quality credit selection, managers can identify resilient issuers, avoid potential pitfalls, and capture attractive risk-adjusted returns, ensuring that investment grade credit remains a compelling option even in uncertain times.

Footnotes

¹ As measured by the Bloomberg Global Aggregate Corporate Total Return Index (EUR hedged)
² As measured by the Bloomberg Global Aggregate Treasuries Index (EUR hedged)