The world’s largest asset management firm explains why it has turned to investment-grade bonds as the market focuses on an impending downturn.
Investment-grade bonds now look more attractive to BlackRock than equities, as attractive valuations, strong balance sheets and moderate rollover risks suggest they may hold up better in a downturn.
The group – which is the world’s largest asset management company, with around $9.6 billion – took a neutral stance on developed market equities in May, citing “a deteriorating macro outlook”.
This followed comments by Federal Reserve Chairman Jerome Powell, who had insisted the central bank would raise interest rates until inflation began to fall back to a healthy level. BlackRock, meanwhile, believes that “reality will be more complex” and this approach threatens to push the economy into recession.
In its latest note, BlackRock said it now prefers Investment Grade (IG) credit to equities on a tactical horizon, as it believes they are better positioned to weather a new market regime characterized by higher volatility. high.
Quoting the chart below, BlackRock’s Chief Fixed Income Strategist Scott Thiel said: “Returns look more attractive than at the start of the year, in our view. This is due to a spike in government bond yields (red area in the chart) and widening spreads (yellow area), the risk premium investors pay for holding IG bonds relative to to their government counterparts.
US Treasury yield and IG credit spread, July 2021-July 2022
Source: BlackRock Investment Institute, with data from Bloomberg, July 2022. The yellow stacked area shows the adjusted spread for investment grade credit options of the Bloomberg Global Aggregate Credit Total Return Value Unhedged Index in US dollars relative to US Treasuries in percentage points. The red area shows the performance of US Treasuries as part of the overall index return.
Since June, markets have been buoyed by the idea that a slowdown in economic growth will prompt central banks to ease their tightening programs, causing bond yields to fall and equities to rise more than 10%.
“We still like IG credit at these levels. Spreads have only narrowed slightly as investors turn to equities,” Thiel continued.
“Additionally, we believe higher coupon income provides a cushion against another surge in yields as markets price in the continued inflation that we anticipate. Equity valuations, meanwhile, do not yet reflect the possibility of a significant downturn, so earnings estimates are still optimistic, in our view.
BlackRock strategists also believe Investment Grade companies are in “good shape”, pointing to low debt service levels, falling leverage and the fact that defaults are at their lowest since 2014. Additionally, the number of companies that are promoted from high yield to investment grade status exceeds those that fall in the rankings.
Thiel also said other trends in the corporate bond market support an overweight in credit.
“First, the supply is relatively low. Corporate bond issuance is down nearly 20% this year from 2021, according to S&P. Many issuers might wait to see if funding conditions improve before issuing more debt,” he explained.
“Secondly, refinancing needs do not seem pressing after a strong increase in issuance last year. For example, typical US IG bond issuance of about $1 billion a year easily outstrips upcoming maturities by less than $600 billion a year through 2029, according to S&P data.
Looking ahead, BlackRock disagrees with the market consensus that the global economy will experience a “soft contraction” that will lead to lower rates and lower inflation – it doesn’t believe that a “soft landing” is possible given the current macroeconomic environment.
“Central banks will have to plunge the economy into a deep recession if they really want to crush current inflation – or live with more inflation. We think they’ll eventually do the latter – but they’re not ready to pivot just yet,” Thiel concluded.
“As a result, we expect weaker growth and high inflation ahead. We see bond yields rising and equities at risk of fading again. IG Credit, in our view, is benefiting from relatively high overall returns which reflect moderate default probabilities.