While corporate leverage remains high, and spreads are tight, we believe the US investment grade credit market stands to benefit in 2020 from accommodative monetary policy, lower rates elsewhere, and supply dynamics. We believe this is not a time to take large spread duration risk, but rather to focus on strong fundamental stories at the company level. We favor the front end of the curve for its carry and roll-down over longer-duration positions given expectations for continued strong issuance at the long end of credit curves. In our view, corporate-level decisions on whether or not to reduce leverage will be a key driver of performance this year.

A Look Back at 2019

In 2019, the US investment grade market registered its best performance in a decade, with the Bloomberg Barclays US Corporate Index returning over 14 percent. We primarily attribute this strong performance to the Federal Reserve’s pivot from policy tightening to easing, and improving corporate fundamentals relative to expectations. The Federal Reserve’s rate cuts served to stabilize growth expectations and reduce interest rates, providing a lift to risk assets. More importantly for credit, the Fed’s pivot provides a new window of opportunity for some highly leveraged corporates in the investment grade market to improve their balance sheets.

Looking beyond the Federal Reserve, synchronous easing across all major central banks led to a strong global bid for yield (Figure 1). Specifically, a growing stock of global debt trading with negative yields and ever-growing demand for income from an aging developed-market workforce, drove strong inflows into the still positive-yielding US investment grade market.

At 2019’s start, much of the negative sentiment toward the investment grade market centered on concerns over growth in the BBB-rated share of the market, and the increasing amount of leverage in this rating cohort. Investors were concerned that a wave of downgrades from BBB into the high-yield market would overwhelm investors in that space, leading to poor returns and defaults. However, during 2019, we saw more upgrades from high yield to investment grade than downgrades. Thus, the ratio of “fallen angels” to “rising stars” fell to an extremely low level (Figure 2). Lower rates and abundant liquidity created an opportunity for some firms to recapitalize and term out debt, and gave more astute management teams time to complete asset sales to bring down leverage.

The Economic Backdrop in 2020

The fourth quarter of 2019 brought two significant developments that should serve to reduce recession risks in 2020 and extend the economic expansion. First, the Phase 1 trade deal between the United States and China could prevent further escalation of trade tensions between the two countries. We do not expect trade-related uncertainty to fully recede, given ongoing disagreement over Chinese government support of strategically important sectors of its economy. Still, the trade deal should forestall any further deterioration in business sentiment and could lead to some modest improvement in capital spending.

Second, US monetary policy has shifted into a moderately accommodative stance, leading to a significant easing in financial conditions that will buoy household and business confidence, and support overall economic activity. Policy makers have also signaled a growing willingness to refrain from further rate increases, absent a meaningful pickup in inflation. As we have written elsewhere, this new approach will be formalized around midyear as part of the FOMC’s strategy review, and should result in a commitment to target above-objective inflation for the remainder of the expansion. This strategy shift will support accommodative financial conditions and economic growth modestly above trend; the lack of significant inflationary pressures implies that any rate increases remain far off.

The FOMC’s forthcoming strategy shift — which we believe already impacts communications about future policy actions — has the potential to extend the expansion for reasons beyond simply delaying a resumption of policy tightening. In particular, the strategy shift can mitigate vulnerabilities that have developed in the economy, specifically around declining corporate profit margins and high corporate leverage. Refraining from rate increases — despite persistent above-trend growth and a tight labor market — affords businesses an additional runway to invest in productivity-enhancing technologies that could lower unit labor costs and support profit margins. In addition, if inflation accelerated, it may imply businesses are having success in sharing higher input costs to customers, which could forestall further deterioration in profit margins. The lower-term structure of interest rates resulting from expectations for stable or lower short-term rates can ease the burden on highly leveraged corporations that may have an opportunity to refinance outstanding debt at lower interest rates. Easy financial conditions could also provide an opportunity for some firms to reduce leverage. Whether highly leveraged investment grade firms take advantage of this opportunity remains to be seen.

Finding Opportunities in Investment Grade Credit

Looking to 2020, we believe an accommodative monetary policy stance should continue to support the growth outlook and risk assets. However, unlike 2019, we expect moderate returns and greater return dispersion in investment grade credit. The US investment grade market will need to navigate a number of crosscurrents in the year ahead. An extended economic cycle, lower rates elsewhere, and supply dynamics provide important support for the market. That said, investors cannot ignore that corporate leverage remains high, and both market structure and tight valuations leave the asset class vulnerable. Against this backdrop, we continue to focus on strong fundamental stories at the company level for price appreciation, roll-down, and carry in the front-end of the curve, while avoiding long-dated issues. In our view, a long-term view on fundamentals — coupled with select tactical opportunities mainly within the BBB cohort — will enhance performance this year.

We expect a continuation of 2019’s low levels of new issuance, which should again provide a meaningful tailwind to the asset class. Gross issuance this year is projected at roughly $1 trillion, the lowest since 2013. The drop-off in net issuance will be even more significant, possibly coming in at the lowest level in over a decade (Figure 4).

Still, the maturity composition of new supply may pose risks as corporations are issuing long-tenor bonds at record-low yields. This reduces refinancing risk for issuers and can improve interest coverage over the longer run, but it exposes investors to peak levels of interest rate sensitivity (Figure 5).

Corporate strategy is one of the most useful indicators of future creditworthiness. A few management teams have moved forward with deleveraging plans, and investors have been rewarded by these efforts. Still, it remains to be seen if companies will maintain their commitment to reducing debt. There will be a clear distinction between those firms that are willing to de-lever, and those that can but choose not to. This corporate decision of whether or not to reduce leverage will be one of the key drivers of credit spread performance this year. We believe this market is highly nuanced, and active credit selection will drive performance late in this economic cycle. We are focused on investing in management teams that have clear capital allocation policies, a competitive advantage, and the ability and willingness to de-lever, as spread per unit of leverage is not broadly favorable (Figure 6).

Finally, we remain focused on potential liquidity constraints in the investment grade market. The market has grown to over $7 trillion in par value, while at the same time dealer balance sheets have shrunk meaningfully since the financial crisis, due to regulatory changes and constraints on funding (Figure 7). As a result, periods of heightened volatility and investor outflows may be less orderly than in the past, as there are fewer intermediaries that can absorb and transfer risk. These events will prove challenging for investors to navigate, but they may also present opportunities as prices can deviate meaningfully from fair value. Therefore, we think it will be important to maintain portfolio liquidity to take advantage of these opportunities.

In summary, while the macro outlook this year is generally constructive for risk assets, a neutral view on corporate fundamentals is complicated by tight valuations, and market structure concerns drives our neutral spread duration posture. However, we have active positions across sectors, along the quality spectrum, and across issuer spread curves because unlike 2019, we think rising tides will not lift all boats. We favor the front end of the curve for its carry and roll-down over longer-duration positions given expectations for continued strong issuance at the long end of credit curves. We are also focused on sectors that have strong free cash flow and capitalization, such as banks and telecoms. Finally, we are overweight BBB-rated companies our analysts have identified as having clear capital allocation plans, which will realize synergies post-M&A, and have a strong competitive advantage.