Credit: Get paid to take less risk
- Amid the challenging investment landscape, investors would find refuge in IG credit
- Projections of cash deposit rates are unlikely to outperform IG credit in the medium term
- This is despite the aggressive pace of rate hikes
- History may repeat itself in this hiking cycle and yields remain below prior peaks
- IG credit stands to see capital gains amid repricing of the interest rate environment lower
Income certainty comes at a discount. The investing world has found no shortage of risks in 2022, with the largest commodity moves in a decade, unabating geopolitical tensions around the Russia-Ukraine crisis, widespread volatility around risk assets, and the first 50 bps Fed hike in 22 years. Yet the price for income certainty has scarcely been as reasonable as it has become, with global Investment Grade (IG) yields at c.3.8% – a level not seen in the last 10 years, exceeding even the peak of the Covid-19 crisis.
The false allure of cash. Undeniably, with financial markets seeing sharp declines, it is natural for risk-averse investors to seek the safety of cash. Yet the prospect of facing the highest inflation in 40 years leaves it difficult to imagine that cash would register positive real returns in the medium term. Those who are banking on interest rate hikes to increase the returns of cash may find themselves disappointed on two accounts:
- Ever-lower peak interest rates. Despite the aggressiveness by which the Fed had projected the path of interest rates, history has shown that each subsequent peak in the hiking cycle had always been lower than the last, owing to the secular decline of the long-term neutral rate of interest from (a) ageing demographics, (b) high global debt burdens, and (c) technological disruption leading to a productivity boom. This time may not be different.
- Low terminal rates. Even with the current hawkish estimates, the Federal Open Market Committee (FOMC) median peak rate is presently 2.75%, while the Fed funds futures peak pricing is c.3%, lower than the yield on IG credit. With historically low default rates in high quality credit, there is a high likelihood that IG would outperform cash through this hiking cycle.
Unanticipated upside. We see the asymmetry in outcomes benefiting investors who switch from cash to IG credit. Firstly, should rate hikes proceed as anticipated, investors would still obtain a return on IG credit that exceeds the anticipated higher cash deposit rates. By our estimates, the Fed needs to price in hikes that are c.1% higher than current estimates before cash would outperform IG over a five-year horizon. Secondly, should history repeat itself and the Fed find themselves unable to hike as aggressively as expected, the yields on short-term bonds would reprice lower and result in capital gains for high quality credit. We view this risk-reward advantageous for investors to deploy cash into short-dated (3-5 year duration), high quality credit – capitalising on the certainty of income generation while most other risk assets grapple with volatility.
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