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As Credit Spreads Tighten, Look to Active Management

The potential for a soft landing continues to grow as the Fed indicates rate cuts later this year. A soft landing could cause further tightening in credit spreads, while a divergence from market expectations could lead to sudden widening. It’s an environment that favors active management strategies, whichever way the cards fall.

In recent months, the compression of credit spreads has proved beneficial for high-yield, bank loans, emerging markets, and corporate bonds. Credit spread compression happens when the yield differences between Treasuries and other bonds that share the same maturity shrink.

As Treasury prices fall and their yields rise, investors generally move into other debt instruments. This typically happens when the economic environment is positive or improving, causing narrower spreads. When the economic environment sours, investors sell out of riskier investments like corporate bonds in favor of the safety of Treasuries. This, in turn, causes the spread to widen.

“In January 2024, IG [investment grade] corporate spreads fell below 1% for the first time in nearly two years,” Mark Cintolo, CFA, CAIA, VP and portfolio consultant for Natixis Investment Managers Solutions, explained in a recent paper.

There’s some debate regarding the impact of reduced supply on the corporate bond side. In a high-yield environment, companies may be more reticent to issue debt. This leads to a supply and demand imbalance that can create artificially lower credit spreads compared to their fundamentals, Cintolo explained.

What’s Ahead for Credit Spreads in 2024

Increasing optimism regarding interest rate cuts in the second half and economic resilience could further compress spreads this year.

“If IG corporate spreads stay rangebound, you still get a return advantage over Treasuries of about 1% over the course of the entire year,” wrote Cintolo. Should spreads tighten even further to post-GFC levels of 80 bps, IG corporate bonds would generate outperformance of 1% in addition to yield. Tightening beyond even that to a historic level of 51 bps credit spread generates 2-3% outperformance above yields.

Alternatively, a reversal is also a possibility, particularly given the increased issuance of corporate debt in January. Should companies continue the trend, the increased supply would serve to drive spreads further apart. Moreover, a lower starting point for spreads leads to an asymmetric upside/downside tradeoff.

“And, of course, you still have the growth scare/hard landing scenario, where negative price action from spread widening easily wipes away any yield advantage,” Cintolo explained.

In either scenario, active management proves a boon for investors. In a world of increased credit spread tightening, active managers can pick and choose their exposures, capturing specific opportunities.

Given the increasing return differential within bonds right now, targeted exposure seems sensible. Prime examples of diverging returns include old versus new mortgages, short-duration Treasuries versus their long-duration counterparts, and high and low-rated credit.

“A tighter spread environment requires being more selective,” wrote Cintolo. “Active strategies can enhance yield while avoiding securities with asymmetric payoff profiles.”

Active management also allows for a more rapid response should there be a reversal and credit spreads begin to widen. According to Cintolo, it’s an insurance policy of sorts should the soft landing narrative fail to materialize.

For more news, information, and analysis, visit the Portfolio Construction Channel.

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