Corporate bonds show resilience, earnings in the spotlight

A quarter-end rally was a brief bright spot for the US investment-grade (BBB/Baa and above) corporate bond market in 2022. The Bloomberg US Corporate Investment Grade Index gained 3.6% over the quarter, a loss of 15.8% for the year. The index’s yield to worst fell 26 bps and spreads tightened 29 bps from the start of the quarter as the Fed diverged from a series of 0.75 basis point rate increases to tame inflation.

Risk premiums for investment-grade corporate bonds will likely remain volatile, though rangebound with today's spreads at the tight end, as company earnings released in the first half of 2023 begin to show the impact of tightening financial conditions. Going forward, the potential for significant losses has been reduced as spreads across bond markets have already widened, though not to levels that account for a recession or significant deterioration of fundamentals. Investment grade bonds currently trade at an attractive entry point and should fare better than high-yield bonds in the event of a recession.

Investment-grade corporate fundamentals are signaling a late cycle environment. Leverage levels have declined from their peaks in 2020, but the pace of deleveraging has slowed. Additionally, year-over-year sales and earnings before interest, tax, depreciation and amortisation (EBITDA) have peaked and continue to decline.

Supply remained fairly healthy throughout 2022 and is expected to stay strong into 2023. A pipeline of mergers and acquisitions-related (M&A) deals in energy, health care and utilities are forthcoming. The pipeline is expected to expand in 2023 and new deals should offer attractive pricing relative to the secondary market.

As rate and spread volatility remain elevated in 2023, demand from traditional buyers might lag early in the year. Demand from foreign investors may weaken given the increased costs of hedging and higher yields for domestic bonds. Nevertheless, the potential carry from unhedged exposure could increase demand for corporate bonds if spread volatility declines or stabilises at wider levels. Increased confidence on inflation, the Fed’s rate path, and clarity on the impact from tightening monetary policy could fuel demand for investment grade corporate bonds.

Volatility for US investment-grade corporates will likely continue

M&A issuance pipeline remains healthy