Lena Katsnelson
Robin Marshall
Last year proved a brutal one for fixed income - particularly for US corporate bonds, as credit spreads widened, and US Treasury yields rose sharply. And while the market has rallied since October 2022, recessionary considerations and geopolitical tensions remain notable risks. As such, many investors are turning to strategies that can position their US corporate bond portfolios for resilience in the face of these headwinds.
US corporate bonds: strong relative value emerges after the brutal sell-off in 2022
After 15% negative returns in 2022 overall, the worst this century, as Chart 1 shows, yields on US corporate bonds have risen to 10-year highs - narrowing the gap between bonds and equity yields and pointing to a potential rebound from current valuation levels.
Corporate Bond Returns and Yields over Time (USBIG+HY)
Source: Refinitiv, 31 January 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosure.
The current macro backdrop for US corporate bond returns is mixed, with recession risks remaining, even if default rates are low. However, inflation is now falling, and fed funds futures are signaling the tightening cycle could be coming to an end. This has helped drive the rally in credit since October, led by high yield, which has less duration exposure than IG. Firmer signals from the Fed that the tightening cycle is complete could also shift investor attitudes toward lengthening the duration exposure associated with corporate bonds.
Managing credit risk amid recession concerns
As recession concerns abound, investors are seeking ways to manage credit risk in their US corporate bond portfolios without compromising yield. Upgrading to higher quality credit has typically come at the cost of lower yields - but the current environment presents an opportunity for investors to improve credit quality with less yield tradeoff. Remarkably, as the Chart below shows, investors can now achieve higher yields in AAA-rated credit than they could with BB-rated credit in 2021, even though BB has a significantly higher probability of default than AAA at any given point in history.[1]
Yields over Time
Source: Refinitiv, 31 January 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosure.
Credit sector positioning for recessionary resilience requires accurate sector strategies.
Investors can also use defensive sectors to improve the recession resilience of corporate bond portfolios. Defensive sector strategies have long been popular for equity portfolios, and evidence is emerging that they can also be effective for corporate bond allocations. Accurate mapping between equity and credit sectors has often been difficult for investors because classification procedures have differed, but The Russell Fixed Income and Russell 3000 indexes use the same ICB industry classification, allowing for sector comparison and alignment across bonds and equities.
ICB Sectors: Rating, OAS/Duration and Market Value
Source: Refinitiv's Lipper Fund Database, 31 January 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosure.
While sector strategies are less well-explored in the corporate bond space, an initial review shows some evidence of protective factors between assets. As shown below, defensive sectors such as consumer staples, health care, and utilities have fared better on an OAS/Duration basis when compared to more cyclical sectors such as consumer discretionary and financials, even when taking ratings into account.
Mitigating the impact of unintended geopolitical risk
In addition to recessionary concerns, geopolitical tensions and resulting global economic divergence are also important considerations for investors. While geopolitical risk might appear less pronounced than recessionary risk, it can be a more permanent consideration that has the potential to gather momentum over time. A recent IMF report highlights the risk of global economic fragmentation, after decades of increasing global economic integration, and rapid world trade growth - a trend that can materially impact all facets of economic development and the corporate fixed income market.[2]
Thus, in the face of rising geopolitical risk, investors are taking a closer look at their corporate fixed income portfolio geographic exposures. However, the prevalence of non-US fixed income corporate issuers in the US corporate bond markets and the difficulty of quantifying non-US exposure can make this a challenging exercise.
Launched in 2022, the Russell Fixed Income Index Series is comprised of debt from US public companies with transparent fundamentals—bringing a unique lens to the US fixed income market to help investors mitigate unintended, and unknown geopolitical and global economic fragmentation risk. Broadly, approximately 27% of Russell Fixed Income index constituent revenue is sourced non-domestically—but exposure to overseas markets can vary widely across sectors. As shown, the technology sector derives nearly 60% of revenues from outside of the US, while utilities, health care, telecommunications, and financials source over 90% of their revenues domestically.
Sector Distribution and % Domestic Revenue
Source: Refinitiv, 31 January 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosure.
Constituents of Russell Fixed Income indexes regularly report geographic revenue exposure—giving investors the transparency and opportunity to gauge non-US exposure across sectors, and build portfolios with geographic fragmentation resilience.
A rosy outlook and a thoughtful approach
Achieving greater transparency and accuracy in the credit indices is important for investors at all points of an economic cycle, but even more so during a time of volatility. While the year ahead could hold the promise of opportunity in US corporate bonds, fixed income investing comes with risks that can be hard to quantify and mitigate. Thoughtful approaches to indexing the US corporate market and transparency of corporate fundamentals are key to constructing portfolios that can prove resilient in the face of these risks. More accurate sector mappings between credit and equity sectors and reducing unknown geopolitical risks and exposures in credit portfolios are important steps in achieving this resilience.
For more, visit our page on the Russell Fixed Income Index Series.
[1] Default, Transition, and Recovery: 2020 Annual Global Corporate Default And Rating Transition Study | S&P Global Ratings (spglobal.com)
[2] IMF: Geo-Economic Fragmentation and the Future of Multilateralism, January 2023
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