Keep your spread and earn on it too? The case for intermediate credit

It’s been an eventful start to the year with the collapse of several US banks, a continued battle against inflation, a moving target on the timing and severity of a recession in late 2023 – 2024, and the unknown longer-term consequences of the delayed US debt ceiling resolution. Heightened volatility and an uncertain macro environment have soured market sentiment along with the outlook for risk assets in the near term, but tumultuous periods can also create opportunity. Today, we believe one of those opportunities comes in the form of intermediate credit.

What distinguishes the intermediate credit market?  

Yields are comparable to riskier investments. With lower-for-longer rates in the rearview mirror thanks to higher inflation expectations and Fed hiking activity, we’ve seen a convergence in yields between intermediate credit and riskier options that are either lower on the quality spectrum or further out in maturity. Looking at yields as a ratio between high yield and intermediate corporates (dark blue line in Figure 1) and between long corporates and intermediate corporates (light blue line), we see sustained levels that have only been experienced one other time over the last decade. Today, the yield premium for going down in credit quality relative to intermediate investment grade is about 1.5x versus 2.5x on average over the last 10 years, while extending duration into long corporates offers almost no additional yield pickup. The bottom line is that market participants can potentially lock in competitive yields (if not the same yields) with considerably less risk related to default rates, lower liquidity, and higher interest-rate sensitivity.

Figure 1

Flat rate and spread curves have compressed the yield/spread advantage along the curve. While the Treasury yield curve inversion tends to dominate headlines, it's not the only noteworthy development in the shape of the curve. In our view, the sympathetic rise in yields along the curve, initiated by the shock to the front end, may be underappreciated. An asymmetric response to the rise in yields along the curve forced both the rate and spread pickup between long and intermediate credit to fall to historic lows (Figure 2). Said another way, the flat rate and credit curves allow investors to achieve similar levels of compensation without inheriting the burden of extended interest-rate risk and higher transaction costs.

Figure 2

There may be upside skew in a bull or bear scenario. Whether your base case points to an economic slowdown and falling yields or a resilient economy with stickier inflation, we believe intermediate credit could be uniquely positioned to benefit in either scenario. We believe the recessionary scenario, where the Fed needs to cut rates, would favor shorter maturities, which are more sensitive to Fed policy; i.e., the Treasury curve would be likely to normalize. This suggests intermediate corporates could keep pace with long corporates during a rate rally. Conversely, if yields rise, as they would in the second scenario, our belief is that they would do so uniformly across the curve. The starting points for all-in yields of long and intermediate corporates are nearly identical, but the duration profiles of each would result in markedly different outcomes should yields come under further pressure. When we translate this effect into breakeven¹ terms, meaning how much yields would need to rise to offset the carry or income earned, the case for shorter-dated high-quality corporate bonds looks even more attractive. For example, long corporates would “break even” with only a 40 bps increase in yields; a yield increase beyond this level would result in a negative total return. Intermediate corporates, on the other hand, would need yields to increase by another 1.24% to negate the income earned, as they provide a greater buffer of spread per unit of duration. As shown in Figure 3, the current breakevens for intermediate corporates are at historically high levels.

Figure 3

Why should pension plans consider allocating to intermediate credit?  

Beyond the points above, corporate pensions with LDI strategies may find intermediate credit appealing for the following structural reasons: 

• Natural shift of liability duration toward the belly of the curve: The extraordinary measures taken by the Fed to battle inflation caused discount rates to rise by over 200 bps over the course of 2022 (as per the Bloomberg Long Corporate Aa Index). Many plans experienced a natural reduction in cash-flow liability duration as yields rose, resulting in a structural increase in shorter-term liability cash flows or front-end partials. Plans might have undergone structural liability shifts since first implementing their LDI programs. We know that frozen and closed plans have matured, which reduces duration, but at the same time, plan sponsors have been active in lump-sum payouts and pension risk transfers, which can have varying impacts on liability structure. To ensure liability-hedging strategies are still aligned with the risk profile of the liabilities, we recommend that plans refresh their data and re-underwrite their hedging portfolio allocation.   
• Improved funded status: At the same time, the improvement in funded ratios since year-end 2020 has spurred further derisking. With more capital allocated to the hedging bucket, plans may not need to be as capital efficient within this allocation, opening up a role for intermediate credit to gain spread exposure across the maturity curve. The competitive all-in yields within intermediate credit offer an attractive entry point for plans looking to lock in improvements in funded status without a meaningful give-up in income and return.  
• Credit hedge ratio: Some plans may be overallocated to spread duration in their liability-hedging portfolio after taking into account the implicit spread duration from equities (or, alternatively, the positive correlation between equities and excess credit returns). Derisking into intermediate credit, with its lower spread duration, may help mitigate this “overhedging” while still allowing for attractive income, provided that the plan can use other tools in the hedging portfolio to manage its target interest-rate hedge ratio. 
  
  We would encourage well-funded plans to reevaluate their current asset allocations against their liabilities and target interest rate and credit hedge ratios to determine whether a change is warranted and aligns with the plan’s overall objectives.  
  

While we believe investment-grade intermediate corporates offer potential for sustainable value and downside protection in today’s environment, the heavier composition of the banking sector within this segment of the market could be of concern. Spreads may be more vulnerable as a result, but we think the ample cushion in breakevens, irrespective of the catalyst for a rise in yields, should be able to absorb a portion of losses caused by adverse moves.  

Overall, we think intermediate corporates exhibit a compelling risk/reward profile and relative attractiveness within fixed income. In an uncertain macro environment such as the one we find ourselves in today, active management may play a critical role in navigating credit market volatility. However, the success of a portfolio comes down to manager skill in underwriting risk. 

¹Breakeven defined as a function of yield to worst divided by duration.