Will 2024 see a dash out of cash?

April 22, 2024

In our latest Q&A, Anthony DeMeo and Ian Horn discuss the prospects for investment-grade credit after a busy first quarter for the asset class.

If the big story of 2023 was the dash for cash, with higher base rates leading to record inflows into money market funds,¹ the early part of 2024 has seen something of a reversal, with over US$20 billion of net inflows into corporate bond funds. Investment-grade (IG) credit has been the prime beneficiary.²

Simultaneously, primary activity has been buoyant. In the US, the world’s largest IG market, US$537 billion of new issuance was recorded in the first quarter, 30% up on the US$413 billion reported in the same period in 2023.³ Despite this surge in issuance, credit spreads continue to grind tighter. The option-adjusted spread of the ICE Bank of America US Corporate Index has compressed from just over 160 basis points (bps) in March 2023 to around 90bps in early April this year.⁴

To understand what might happen next, we put the questions to Muzinich portfolio managers Anthony DeMeo (AD) and Ian Horn (IH).

2023 saw record flows into money-market funds in the US and elsewhere. Could we see a reversal this year and what are the implications for IG?

AD: Last year, assets in US money market funds (MMFs) hit a new record of US$6.4 trillion.⁵ With uncertainty around the macro picture in 2023, the big thematic was for investors to park their money in cash, get a risk-free yield north of 5% and wait it out until the Federal Reserve stopped hiking rates.

The expectation now is that the Fed’s next move will be a rate cut. So, we are starting to see some of the money gravitate out of MMFs into risk assets, including investment-grade credit. Even though spreads are tight, the technicals remain strong as market participants are looking at the all-in yield they can get in credit, as the risk for further rate hikes is low. We have seen investors extending duration to lock-in higher yields than they would have earned for many years. This includes pension funds and other liability-driven investors given the improvement in their funding status.

IH: Over the past couple of years, the funding position of defined-benefit pension schemes has improved dramatically (see Figure 1) due to rising interest rates. For much of the past two decades, they have been underfunded and looked beyond credit to make up that shortfall, including equities and private markets. Now the dynamic has changed, they don’t need to take so much risk and can be fully invested in fixed income to meet their liabilities. We have structural buyers of credit due to rates and yields potentially being higher.

The other point on investors who looked for shelter in MMFs last year concerns reinvestment risk. If you're sitting in a MMF and rates fall in a few months’ time, the yield you are getting will reset lower. Part of the gravitation back into credit markets is to lock in these yields and mitigate the reinvestment risk in MMFs and cash deposits. 

IG spreads have compressed to their tightest levels in a couple of years. Is the market starting to become expensive?

IH: It’s more nuanced in terms of European IG. Firstly, European spreads aren't as tight as they are in the US. Secondly, while spreads screen tight if you look at the index average, when you drill down you will see that the long end of the curve – 10 years and over - is driving that tightness. The one-to-10-year part of the market is still 20-25 basis points (bps) wide of where we were before the Fed and ECB began their hiking cycles, whereas the long end is closer to flat in spread terms.

When assessing whether spreads are tight, you also need to consider the right comparative timeframe. While European spreads overall are tighter than the 10-year average, this was a period characterised by negative interest rates. This effectively put a floor under how tight credit spreads could go, given yields were already so low.

But if we look back to a period where interest rates were comparable to where they are now - pre-2011 - spreads were much tighter than they are today (See Figure 3).

When interest rates were negative and yields were very low, spreads needed to be wider because that was the main source of value in credit. When you have interest rates around 4%, spreads can be much tighter, and the asset class can still make sense in terms of all-in yield and total return.

“While the low-hanging fruit may have been picked, there are still opportunities.”

Anthony DeMeo

AD: From a US perspective, when we look back to the early 2000s, we are not far off those tights. But it’s important to remember spreads can remain range bound for extended periods unless there is a catalyst that impairs liquidity in the broader system, whether that’s a growth shock or geopolitical event. Without that, it seems unlikely spreads will move materially wider. So, while the low-hanging fruit may have been picked, there are still opportunities, especially with volatility subdued.

Unlike high yield, where spread tightening has coincided with a shrinking market, IG has seen tighter spreads despite strong primary issuance. Can that continue?

AD: It’s important to look at net supply. Although new issuance is high, when you factor in redemptions and liability-management activity, net supply is quite low. That’s likely to remain that way in the near term, with over $750 billion in maturities over the next two years. Issuers have generally been prudent in terms of managing their balance sheets, which has bolstered the technical picture. We have seen significant oversubscriptions for new issuance, which shows the robustness of the supply-demand dynamic.

IH: In Europe, we haven't seen the same bumper deals as the US. When you look at how spreads have performed, it is apparent demand is outstripping supply. And, given the structural inflows we have seen coming into the asset class, there is every likelihood the strong technical picture will continue. Rather than the opportunistic issuance that drove activity when rates were low, we’re mostly seeing companies come to market when they need to raise debt or refinance.

Are there any sector developments you would highlight?

IH: We still feel banks screen relatively cheap, particularly for short-duration securities such as Tier 2s. As to why banks trade wider, there are still concerns around commercial real estate exposures and the overhang following last year’s events at Credit Suisse and US regional banks. In general, though, we think the sector is in decent shape and the premium over corporates remains attractive.

“The big question is whether you are getting appropriately compensated to take more risk.”

Ian Horn

The last few months has been all about spread compression. The big question is whether you are getting appropriately compensated to take more risk in sectors like real estate and autos. Some of these compression trades are maturing, so now might be an opportunity to rotate out of those into other parts of the market where that compression theme has lagged.

AD: Given the lack of spread dispersion in the US, one area we are focused on is identifying rising stars or investing in the capital structures of high-yield borrowers that have secured IG-rated bonds, which trade cheap to broader comparables. As for specific sectors, power generation and natural resources are interesting as they are potential beneficiaries of the artificial intelligence/ electrification boom. Beyond that, we also see opportunities in hybrids issued by financials that might be attractive call candidates. 

Much of the bullishness surrounding credit is related to the possibility of a soft landing. What are the risks to that bullishness?

IH: The soft-landing scenario depends on interest rates and the Fed and ECB delivering on rate cuts. The main risk is a reacceleration of inflation. On that, the biggest concern surrounds energy prices, especially considering continued geopolitical headlines. But, so far, we have seen little in the communications from central banks that they will deviate from monetary loosening, if perhaps at a slower pace than the market anticipated.If you take the investment-grade market in isolation and assess corporate fundamentals, there is no need for concern. Leverage hasn’t spiked and interest coverage remains healthy. Moreover, earnings have held up well and defaults in high yield have remained modest. Any risks are more likely to be macro in nature rather than credit-specific.

 

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed by Muzinich & Co are as of April 2024 and may change without notice.

References

1.Fitch Ratings, ‘Global Money Market Fund Flows Update: 2023,’ March 25, 2024
2.Financial Times, ‘Investors pour money into US corporate bond funds at record rate’, March 24, 2024
3.SIFMA, ‘US Corporate Bond Statistics’, as of April 2, 2024
4.ICE index platform, as of April 8, 2024
5.Office of Financial Research, ‘U.S. Money Market Funds Reach $6.4 Trillion at End of 2023’, March 26, 2024
6.Fitch Ratings, U.S. Investment-Grade Bond Market Monitor, February 16, 2024

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Index Descriptions

ER00 – The ICE BofA ML Euro Corporate Index tracks the performance of EUR denominated investment grade corporate debt publicly issued in the eurobond or Euro member domestic markets. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity, a fixed coupon schedule and a minimum amount outstanding of EUR 250 million. 

C0A0 - The ICE BofA ML US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market. Qualifying securities must have an investment grade rating (based on an average of Moody’s, S&P and Fitch), at least 18 months to final maturity at the time of issuance, at least one year remaining term to final maturity as of the rebalancing date, a fixed coupon schedule and a minimum amount outstanding of $250 million.

UR00 - The ICE BofA Sterling Corporate Index tracks the performance of GBP denominated investment grade corporate debt publicly issued in the eurobond or UK domestic market.

UR01 - ICE BofA 1-3 Year Sterling Corporate Index is a subset of ICE BofA Sterling Corporate Index including all securities with a remaining term to final maturity less than 3 years.

UR02 - ICE BofA 3-5 Year Sterling Corporate Index is a subset of ICE BofA Sterling Corporate Index including all securities with a remaining term to final maturity greater than or equal to 3 years and less than 5 years.

UR03 - ICE BofA 5-7 Year Sterling Corporate Index is a subset of ICE BofA Sterling Corporate Index including all securities with a remaining term to final maturity greater than or equal to 5 years and less than 7 years.

UR04 - ICE BofA 7-10 Year Sterling Corporate Index is a subset of ICE BofA Sterling Corporate Index including all securities with a remaining term to final maturity greater than or equal to 7 years and less than 10 years.

UR09 - ICE BofA 10+ Year Sterling Corporate Index is a subset of ICE BofA Sterling Corporate Index including all securities with a remaining term to final maturity greater than or equal to 10 years.

C1A0 - ICE BofA 1-3 Year US Corporate Index is a subset of ICE BofA US Corporate Index including all securities with a remaining term to final maturity less than 3 years.

C2A0 - ICE BofA 3-5 Year US Corporate Index is a subset of ICE BofA US Corporate Index including all securities with a remaining term to final maturity greater than or equal to 3 years and less than 5 years.

C3A0 - ICE BofA 5-7 Year US Corporate Index is a subset of ICE BofA US Corporate Index including all securities with a remaining term to final maturity greater than or equal to 5 years and less than 7 years.

C4A0 - ICE BofA 7-10 Year US Corporate Index is a subset of ICE BofA US Corporate Index including all securities with a remaining term to final maturity greater than or equal to 7 years and less than 10 years.

ER01 - The ICE BofA ML 1-3 Year Euro Corporate Index is a subset of ICE BofA ML Euro Corporate Index including all securities with a remaining term to maturity less than 3 years.

ER02 - ICE BofA ML 3-5 Year Euro Corporate Index is a subset of ICE BofA ML Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 3 years and less than 5 years.

Index Descriptions

ER03 – ICE BofA 5-7 Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 5 years and less than 7 years. Inception date: December 31, 1995

ER04 - ICE BofA 7-10 Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 7 years and less than 10 years.

ER09 - ICE BofA 10+ Year Euro Corporate Index is a subset of ICE BofA Euro Corporate Index including all securities with a remaining term to final maturity greater than or equal to 10 years.

ER40 – The ICE BofA ML BBB Euro Corporate Index is a subset of the ICE BofA ML Euro Corporate Index including all securities rated BBB1 through BBB3, inclusive.

C7A0 - BofA 7+ Year US Corporate Index is a subset of ICE BofA US Corporate Index including all securities with a remaining term to final maturity greater than or equal to 7 years.

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