- Increasingly during the fourth quarter, data supported views that the Federal Reserve (Fed) was near if not at the end of its nearly two-year campaign to control inflation through interest rate hikes and economic growth might slow rather than retract.
- Concerns over government debt levels, labor supply, and the Fed eased, reassuring investors about the prospects for risk assets, including corporate bonds.
- The Bloomberg (BBG) U.S. Corporate Investment Grade (IG) Bond Index (the Index)  option-adjusted spread (OAS) narrowed by 22 basis points (bps) on the quarter and 31bps on the year, ending at 99bps.
- Our base case outlook is for a low-growth or mild recession in 2024 stemming from the persistent drag of tight monetary policy during the last two years and the potential for fiscal policy to turn from a tailwind to a headwind.
- Primary risks to our outlook will be continued economic strength fueled by wage gains, resilient consumer spending, and a still tight labor market.
Investment Review and Outlook
A rally in risk assets accompanied favorable economic data and investment conditions.
The Fed held interest rates steady at its October 31 and December 12 meetings. In October, inflation and hiring data for September showed some signs of moderating, while consumer confidence readings were lower.2 In addition, a persistent rise in long-term Treasury rates during October had the effect of tightening financial conditions.
Government data for October released in November showed further signs of easing inflation.3 Economic growth remained robust, as reflected in rebounding consumer confidence readings from the Conference Board4 and the second estimate of third quarter gross domestic product (GDP) from the Bureau of Economic Analysis (BEA), which jumped up to 5.2 percent quarter-over-quarter (later revised in the BEA’s third estimate to a still robust 4.9 percent compared with the second quarter’s 2.1 percent reading).5
BEA data released in December also showed solid corporate performance. Profits from current production increased $108.7 billion in the third quarter. Profits of domestic financial corporations increased $9.0 billion in the third quarter. Profits of domestic nonfinancial corporations increased $90.8 billion.6
In December, according to median projections in the Fed’s updated Summary of Economic Projections (SEP), Fed officials think there will be three rate cuts in 2024. The cuts would bring the Fed’s target interest rate closer to 4.6percent from the current range of 5.25 percent to 5.5 percent.7 In commentary, Federal Open Market Committee (FOMC) members indicated expectations for inflation to track lower toward the Fed’s 2 percent target during the year ahead.
In response to the favorable events and conditions during the quarter, sentiment for bonds improved. For the quarter ended December 31, the Bloomberg (BBG) U.S. Corporate Investment Grade (IG) Index8 total return was 8.52 percent. The excess return compared with duration-matched Treasuries was 2.03 percent during the same period.
At Breckinridge, the Investment Committee’s (IC) base case calls for a low-growth or mild recession for 2024, as the drag from tighter monetary policy persists and fiscal policy turns from a tailwind to a headwind. The labor market shows some signs of cooling and inflation data is moving towards the Fed’s 2 percent target. The main risk to the outlook is continued economic strength fueled by wage gains, resilient consumer spending, and a still tight labor market.
The IC, which shares the view that the Fed is done raising rates, made no changes to its Treasury rate forecasts, given the wide swings in yields during the quarter. Concerns over large fiscal deficits and increased Treasury supply have faded, for now. With nominal bond yields still relatively high, we view IG fixed income as attractive. Spreads seem to be pricing in a soft-landing scenario and would appear to offer little upside from here. Our risk posture is defensive in credit, based on valuations and our forward read of the economy.
IG Spread Compression Was Driven by Long Corporates in 2023.
Corporate spreads continued to move tighter and compressed by 22bps in the fourth quarter of 2023 (4Q23). For the year, spreads were 31bps tighter with BBBs (38bps tighter) outperforming Single-As (25bps tighter). Industrials (34bps tighter) outperformed Financials (28bps tighter) and Utilities (24bps tighter).
Credit curves steepened slightly in 4Q23. The BBG U.S. Corporate 1- to 5-Year Index9 (1- to 5-Year Index) tightened 21bps, while the U.S. Corporate 10+-Year Index10 (10+-Year Index) tightened 18bps. Year-to-date (YTD), credit curves flattened with the 1- to 5-Year Index and the 10+-Year Index tightened by 14bps and 42bps, respectively.
At the start of 2023, the spread gap between these indices was 68bps and it compressed to 39bps at year-end. It has averaged 87bps since 2015. Should spreads widen, the long end may be more vulnerable to mean reversion given relative valuations.
After a Strong Year, Excess Returns May Be More Muted in 2024
At January 1, 2023, the IG OAS spread was 130bps and finished at 99bps. The excess return, or the return over duration-matched Treasuries, was 455bps.11 For bonds with shorter maturities (1- to 5-year), excess returns were a more modest 185bps, compared to longer-maturity (10+-year maturity) bonds at 763bps.
In past years, when IG spreads have a starting spread near 100bps, excess returns have been relatively modest—in a range between 25bps to 50bps—on a 12-month forward look. If spreads do not move, the excess return is comparable to the credit spread.
At current IG valuations, breakeven spread widening on an annualized basis, is about 15bps.12 However, breakeven spreads are quite different, with short-end (1- to 5-year) maturity bonds around 30bps, while long-end (10+-year maturity) corporates are about 10bps.
Corporate Bond Funds Flows and Holders Were Steady in 2023.
Net purchases of U.S. corporate bonds by large holders (for example, insurance companies, foreign investors, and investment funds) were about $470 billion, on a seasonally-adjusted annual rate, through the 3Q23, per Fed data.
U.S. corporate bond holdings for each of these investors increased modestly in 3Q23 year-over-year (Y/Y). Insurer, foreign, and fund holdings were up 5.3 percent, 5.7 percent, and 1.5 percent, respectively.
Smaller corporate bond investors and holders, including households and U.S. depository institutions, were negative net purchasers of corporate bonds over the last two quarters of 2023.
Isolating IG bond mutual fund and exhange-traded fund (ETF) flows tells a similar story. Through the end of December, IG ETFs reported $77 billion of inflows with IG non-ETFs logging about $46 billion of inflows.
Corporate Bond Supply ends Q4 with a Whimper and Flattish Y/Y.
IG corporate supply was $1,253 billion in 2023, down slightly from $1,257 billion in 2022. Net supply, which in this case takes the difference between Index par value Y/Y, was about $426 billion in 2023, up from $374 billion in 2022.
In recent years, corporate supply has averaged $1.2 trillion, while net supply was typically around $500 billion. A notable shift was Finance supply, which at $488 billion in 2023 was down from $584 billion in 2022, based partly on sector spread volatility.
About $14 billion in assets flowed into of U.S. IG bond funds in 4Q23, per EPFR Global. On a YTD basis, EPFR Global reports $123 billion of net inflows into IG bond funds, split about equally between IG bond mutual funds and IG ETFs.
Leverage Shows Modest Deterioration While Credit Quality Is Stable.
Financial leverage (that is, total debt to earnings before interest, taxes, depreciation and amortization (EBITDA)) for the mean U.S. IG issuer rose slightly to 3.1 times for the most recent quarter compared to the prior year. Leverage peaked at about 3.5 times in 2020 and has trended lower since then.
Rating agencies Moody’s Investors Service and S&P Global each averaged an upgrade-to-downgrade ratio of about 1.2:1 for U.S. IG corporate issuers in 2023. At the height of the COVID-19 pandemic and the economic and market dislocations in 2020, the agencies downgraded about two IG issuers for every one upgrade.
Beginning in 2021, and over the past three years, issuer fundamentals have stabilized and improved. Cash liquidity has risen, debt has been termed out and balance sheets repaired. Since then, the upgrade-to-downgrade ratio has averaged 2.25:1.
For 2024, we would expect a more balanced ratio of upgrades-to-downgrades, perhaps with a tilt towards downgrades, particularly if the economy slows materially. Leverage has creeped up and liquidity has been tempered, although margins remain stable.
Liquidity Declines Modestly While Operating Margins Are Stable.
Cash as a percentage of debt for the mean IG issuer was 15 percent at 3Q23 and has declined steadily since peaking at 19 percent at 3Q20, during the height of the pandemic. Mean cash balances have declined, but they are at or above the level during the 2015 to 2019 period.
The Capital Goods and Consumer Cyclical sectors saw the largest drop in cash as a percent of debt, moving from 26 percent and 35 percent at 3Q20 to 17 percent and 23 percent at 3Q23, respectively. Notable increases were seen in the Basic Industry and Energy sectors.
The Generally Accepted Accounting Principles (GAAP) EBITDA margin as a percent of revenue for the mean IG issuer was 27.3 percent at 3Q23, down slightly from 27.8 percent at 3Q22, but up from the prior two quarters.
Consistent with the recent trend, we expect cash as a percent of debt for 2024 to move lower. Margins have remained in a tight range and, with inflation declining, may see some modest improvement.
In a development intended to bring greater consistency to sustainability reporting, the ISSB issued its first two sustainability standards: International Financial Reporting Standards (IFRS) S1 and IFRS S2.13 The standards incorporate recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) to address disclosure requirements related to a company’s governance, strategy, risk management, and sustainability-related metrics and targets.
IFRS S1, IFRS S2, and SASB identify sustainability issues most likely to affect financial performance and enterprise value for 77 industries. The standards are intended to establish a global baseline for disclosures: IFRS S1 on sustainability-related risks and opportunities, IFRS S2 on climate-related disclosures. The standards are designed to work alongside financial statements to help investors assess companies’ environmental, social and governance (ESG) credentials, as well as standardize and potentially reduce corporate reporting burdens.
The International Organization of Securities Commissions endorsed the ISSB’s corporate reporting standards for sustainability and climate risk. IFRS measures for financial accounting are used in 168 jurisdictions outside of the U.S., as of December 18, 2023.
The U.S. relies on the GAAP, as adopted by the Securities and Exchange Commission (SEC). The SEC is expected to release its own reporting requirements related to climate risk for securities issuers (See SEC Proposes Climate-Related Reporting Requirements). In a comment letter, Breckinridge Capital Advisors encouraged the SEC to consider alignment of its proposed climate rule with ISSB’s draft climate disclosure standard to reduce disclosure complexity and confusion while helping to clarify corporate climate preparedness across countries and regions.
Briefly, the ISSB-promulgated standards address the following:
- IFRS S1 (General Requirements for Disclosure of Sustainability-related Financial Information) requires company disclosures about all sustainability-related risks and opportunities that could reasonably be expected to affect the company’s cash flows and access to finance or cost of capital over the short, medium, or long term. In addition, it offers requirements for the content and presentation of required disclosures so that the information disclosed is useful to primary users in making decisions relating to providing resources to the company.
- IFRS S2 (Climate-related Disclosures) requires company disclosures about climate-related risks and opportunities that could reasonably be expected to affect the company’s cash flows, and its access to finance or cost of capital over the short, medium, or long term.
We have long valued and supported the work of the Sustainability Standards Accounting Board (SASB) to bring ESG reporting standards to the marketplace. For example, Breckinridge joined the SASB Investor Advisory Group as a founding member in 2016. More recently, Breckinridge signed the COP 28 Declaration of Support to publicly state our commitment to “advancing the adoption or use of the ISSB’s Climate Standard [IFRS S2] as the climate global standard.”
 The Bloomberg U.S. Corporate IG Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. You cannot invest directly in an index.
 The Bureau of Labor Statistics (BLS) reported that Core Personal Consumption Expenditures (PCE) Price Index (ex-food/energy) dropped to 2.4 percent over the third quarter, down from 3.7 percent in second quarter and 5 percent in the first quarter. The BLS reported that companies added 150,000 workers in October, lower than September’s 279,00 gain, which was revised lower, and the smallest increase since June. The unemployment rate rose to 3.9 percent from 3.8 percent in the prior month. The Conference Board's index of consumer confidence decreased in October, due to increased pessimism about the present situation and future expectations. Confidence has now fallen in the past three months, highlighted by declines across categories in October.
 On November 3, the Bureau of Labor Statistics (BLS) reported that labor market conditions eased in October, with payrolls rising a softer-than-expected 150,000, the unemployment rate increasing to 3.9 percent, the workweek edging lower and average hourly earnings growth softening. On November 14, the BLS reported weaker-than-expected Consumer Price Index (CPI) data, led by a sharp pullback in shelter inflation and deceleration in core services inflation. On November 30, the Bureau of Economic Analysis reported that October Personal Consumptions Expenditures (PCE) prices data showed a material slowing in core inflation pressures, akin to the CPI release for the same period. Also on November 30, the U.S. Department of Labor data showed more Americans filing for jobless claims as the month closed, and the overall number of people in the U.S. collecting unemployment benefits rose to its highest level in two years.
 On November 28, the Conference Board reported that its index of consumer confidence increased to 102.0 in November reflecting higher optimism about future expectations. The increase broke a three-month string of declines in confidence, which peaked at 114.0 in July. You cannot invest directly in an index.
 “Gross Domestic Product (Third Estimate), Corporate Profits (Revised Estimate), and GDP by Industry, Third Quarter 2023,” Bureau of Economic Analysis, December 21, 2023.
 “Three rate cuts are on the table for 2024,” CNN, December 13, 202.
 The Bloomberg U.S. Corporate Investment Grade Bond Index is an unmanaged market-value-weighted index of investment-grade corporate fixed-rate debt issues with maturities of one year or more. You cannot invest directly in an index.
 The Bloomberg Barclays MSCI US Corporate 1- to 5-Year Index measures investment grade, fixed-rate, taxable corporate bonds. Bonds in the index must have a maturity greater than or equal to 1 year and less than, but not equal to 5 years. You cannot invest directly in an index.
 The Bloomberg U.S. Corporate 10+-Year Index measures the performance of the investment grade, USD-denominated, fixed-rate, taxable corporate bond market securities with maturities of 10 years and greater. You cannot invest directly in an index.
 Annualized excess return of Bloomberg U.S. Corporate Index equals price return plus coupon return (with reinvestment) minus total return of duration-neutral Treasury.
 Breakeven spread is calculated by dividing OAS by duration for a given bond or Index to assess how much a corporate spread can wide versus a duration-matched Treasury over a one-year horizon before the two securities or Indices have the same total return.
 Breckinridge created its internal sustainability rating gradient ranging known as “S1-S4” in 2011; IFRS developed the S1 and S2 nomenclature independently.
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