Mid-Year Update

July 2022

At the conclusion of the second quarter, the corporate bond market, suffered through one of the worst starts to the year in decades. Both government yields and corporate risk premiums have risen concurrently, initially reflecting heightened inflationary and geopolitical concerns, and now most recently elevated credit fears. The latest bout of volatility, beginning in June, has focused the market discussion on a possible recession some time over the next twelve months, relating to efforts by central banks to aggressively dampen economic activity in their fight against inflation. While the probabilities have risen, we are not convinced that a recession is certain to occur. When factoring questions on the timing and the severity of any potential economic slowdown, there remains a lot to assess. Going forward, our focus will be to balance the fundamental macroeconomic and company specific risks, along with opportunities that present themselves as companies require access to funding.

Corporate fundamentals remain supported by healthy balance sheets and liquidity profiles, as companies continue to benefit from the efforts since the pandemic to shore up their finances. That said, the stresses caused by the rise of inflation will prove a test for margins. We await the next two earnings seasons to assess the trajectory of cost pressures and profitability in general. Ultimately, we believe corporations will weather a slowdown better than past cycles, as default levels should remain subdued.

The investment grade new issue market has managed through an on again/off again mentality. While closed during periods of excessive volatility, investors have shown a willingness to add credit risk, albeit at concessions. Outside of recessionary periods, it is difficult to recall a market in which concessions have been demanded and received by investors for so long. Issuance from banks has dominated market flow. Aside from financials, the relatively benign new issue calendar has helped to mitigate market volatility.

Risk premiums have approached the non-recessionary highs experienced since the Global Financial Crisis, which are approximately at the mid-point enroute to traditional recessionary levels. On an all-in basis, aggregate yields are attractive given the combined selloff of both government yields and corporate risk premiums. Despite the generally weaker market tone, there have been periods of aggressive risk rallies, relating to perceptions of an improvement in the fundamental macro environment or short covering. Risk premiums are largest for financial issuers given their heavy supply volumes. As a result, the relative value attractiveness of this sector stands out on a historical basis.

The portfolios’ composition continues to emphasize a credit overweight. The aggressive turn in sentiment and valuations leave us to view that much weakness is being priced in during the near term. That said, we will emphasize portfolio de-risking during market rallies in the absence of any material fundamental improvement. We have increased exposure to higher quality issuers, including financials, at attractive valuations. Portfolio duration has been increased given our view that yields represent good value and should provide a ballast if, in fact, a more significant downturn materializes.