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Investors holding the highest quality corporate debt may have to endure the pain of poor returns and wider credit spreads for at least the next six months as the Fed faces the uphill challenge of raising US interest rates enough to curb inflation but, at the same time, avoid causing a recession.

The Fed is expected to hike US interest rates by 50bp after its two-day policy-setting meeting in June and follow-up with a similar-sized hike in July to rein in inflation.

Fed Chair Powell’s hope is to deliver a soft landing for the US economy even as Russia’s ongoing invasion of Ukraine wreaks havoc with global supply chains and adds to existing inflationary pressures caused by an uneven post-pandemic reopening of the US economy and heavy US fiscal stimulus.

“It is still too early to confidently predict that a recession is inevitable based on what the economic data is telling us right now,” said Edward B. Marrinan, SMBC Nikko Securities’ Macro Credit Trading Strategist in the latest IGM Credit Corner Vlog.

“While there is good reason to be fearful of a recession…. it would be premature to make that kind of forecast with certitude” added Marrinan.

The Fed’s well-telegraphed plans for interest rate hikes have resulted in a notable tightening in financial conditions, reflected in a sharp sell-off in equities, the approximate 133bp back up in the benchmark 10yr Treasury note yield this year, the big jump in residential mortgage borrowing rates, and reduced consumer confidence, among other measures, he said.

“The Fed will have to calibrate its policy response to achieve a soft landing – slow inflation without driving the economy into a contraction,” said Marrinan. “It’s a pretty tall order,” he added.

Lingering doubts about the Fed’s’ ability to quickly lower inflation have contributed to the marked widening of spreads across the fixed income markets, including those on the US investment grade asset class.

“USD investment grade credit spreads have widened over 57bp to +155bp, the widest level of the year; even more damaging, has been negative USD IG total return over 13.3%, a horrifying number,” said Marrinan.

“It's not my expectation that spreads are going to widen considerably from their current levels, but neither do I see a strong catalyst for spreads to compress, until we get through all these uncertainties ...so we may have to live with this poor performance,” said Marrinan.

And while Marrinan does not expect USD IG credit spreads to revisit the +200bp level reached in March 2020 at the early stage of the COVID shutdown (before subsequently rising to a high of T+401bp by March 23, 2020), neither does he rule out that possibility.

“For the USD IG index spread to widen to +200bp, something difficult has to happen, like the intensification of the Russia-Ukraine situation, some other geopolitical threat, upset in the commodity universe or if the market concludes the Fed had perpetrated a policy mistake. At present, I don’t put a high probability that spreads will widen to this level,” he added.

The difficult backdrop however has not completely dampened demand for USD IG credit exposure the USD IG primary market. While the new bond issuance has been challenged in recent weeks by broader market volatility, most deals have been well-subscribed even as investors exhibited greater selectivity.

“There is healthy demand among institutional investors to own US corporate debt in the new issue market because the price discovery and valuations are clear… but they are still cautious about secondary market exposure until they have greater visibility in the next three to six months,” added Marrinan.

Through this period of volatility, Marrinan’s preference is for lower rated, shorter duration USD IG exposure.

“The current all-in yield of 4.4% offered by the USD IG index is thus a very attractive level,” he said.

To view the VLOG, go to:

https://www.informagm.com/

-Shankar Ramakrishnan

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