Following a rapid tightening of policy rates, investors face high uncertainty about the direction of the economy and the strength of consumer and corporate balance sheets. Doubts persist as to whether equity market multiples or credit spreads compensate adequately for these uncertainties. But against this background, the yield from short-maturity investment-grade corporate bonds is highly attractive.
Predictability amid uncertainty
As a bond approaches maturity, the (fixed) income becomes a more important determinant of return than the (fluctuating) capital valuation. A short maturity reduces the sensitivity of the bond’s price to changing rates, improves the visibility of the issuer’s capacity to repay coupons and reduces the impact of coupon reinvestment.
Figure 1. Starting yield is a stronger determinant of subsequent return in short-duration fixed income
Source: Refinitiv, Neuberger Berman. Data as of December 15, 2023.
We regard current yields of 4-6% in investment grade credit as attractive in themselves. Moreover, the current flatness of both yield and credit curves means there is no extra yield available in exchange for holding longer-dated bonds. And at shorter maturities, where starting yield is closely correlated with total return, there is the potential to generate incremental estimated return over cash while preserving much of the predictability and flexibility of cash.
In a time of high uncertainty around economic and credit conditions, any kind of predictability becomes valuable.
Extension risk
Yet, there is potential to squeeze more spread and yield out of the short-duration credit market than we currently see at the index level.
It might seem strange to include corporate hybrids in our short-duration universe given how long-dated they tend to be – sometimes even perpetual. However, these securities are callable and their price tends to trade in line with the first call date, because it is extremely rare for them not to be called.
Corporate hybrids are subordinate to senior bonds because they have equity-like features: not only can they be extended beyond their call dates, but their coupon payments can be deferred without a default. Credit rating agencies therefore treat them as half equity and half senior debt, making them an attractive option for issuers looking to optimise their cost of capital. However, that ‘hybrid’ status is typically forfeited if the security is extended, effectively making it expensive senior debt.
That is why we believe ‘extension risk’ tends to be modest. It is currently quite well compensated, however: after trading relatively tightly to senior investment grade credit through 2020 and 2021, hybrids became increasingly attractive through 2022 and remains at relatively wide levels today.
Securitised products
For investors concerned about the impact on corporate bonds of the economic slowdown, securitised products offer diversification into more consumer-oriented debt (from credit cards and auto loans to timeshares and cellphone contracts) and more unusual corporate sectors (such as telecommunications infrastructure, aircraft and equipment leasing).
We think short-duration US agency mortgage-backed securities are particularly attractive at the moment, offering yields only around 50 basis points lower than US corporate bonds, with a substantially higher-quality average credit rating. In our view, this attractive pricing is mainly due to the buyer base shifting away from banks (which tend to be buy-and-hold investors) to asset managers (which tend to trade more often) – an established trend amplified by the mini-banking crisis in spring 2023.
The sector is supported by relatively resilient consumer and housing-market dynamics. Moreover, the key risk of early or faster-than-scheduled prepayment is muted, as most borrowers are happy to stick with the lower rates they locked in some years ago rather than refinance at today’s higher rates. Taking short-duration exposure mitigates that risk still further.
Finally, for non-US dollar investors, the cost of currency hedging has eased substantially over the past year.
A little predictability at a time of uncertainty
Investors face considerable uncertainty in the months ahead. The path of inflation remains uncertain; how central banks will react to that path remains still more uncertain; and the underlying strength of growth in the major economies depends to a large extent on the lagged impact of rate hikes and the potential policy responses to come.
Against this backdrop, we believe short-duration investment grade credit comes with a lot of advantages. Yields are at attractive levels and are likely to correlate strongly with total returns over the coming year. With additional spread available to flexible strategies that explore extension risk and securitised products, we think short-duration investment grade credit is attractive for fixed income investors as they head into 2024.
David Brown is Senior Portfolio Manager and Global Co-Head, Investment Grade and Sergejs Prala is Portfolio Manager, Global Investment Grade at Neuberger Berman.
This is an edited version of an original article published here.