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Highlights Corporate Bond Returns & Fed Tightening: Corporate bond performance varied considerably during the past four Fed tightening cycles. Our analysis of these periods suggests that valuations and the slope of the yield curve are the two most important factors to monitor. Investment Grade Strategy: Given tight valuations, our analysis of past Fed tightening cycles suggests that it will make sense to downgrade our allocation to investment grade corporates from neutral (3 out of 5) to underweight (2 out of 5) once we are confident that the yield curve has shifted into a flatter regime. High-Yield Strategy: De-risking will also be warranted in the high-yield space as the yield curve flattens, but relative valuations dictate that investors should retain a preference for high-yield over investment grade corporates. Feature It is now apparent that the Federal Reserve intends to kick off the next rate hike cycle at the March FOMC meeting. This move has been strongly hinted at in recent Fed speeches and it will be telegraphed more officially when Jay Powell addresses the media tomorrow. In preparation for upcoming rate increases, last week’s report looked at Treasury returns during prior periods of Fed tightening.1 This week, we extend that analysis to the corporate bond market. Specifically, we consider the excess returns that were earned by both investment grade and high-yield corporates during the four most recent rate hike cycles.2 We conclude that a defensive posture toward credit risk will be warranted as Fed tightening gets underway. While we aren’t quite ready to downgrade our recommended allocation to corporate bonds today, we expect to do so within the next couple of months. Corporate Bond Returns During Rate Hike Cycles Table 1 presents excess returns for both the Bloomberg Barclays Investment Grade Corporate Bond Index and the Bloomberg Barclays High-Yield Corporate Bond Index in each of the past four Fed tightening cycles. As was the case last week, we define each tightening cycle as spanning from the first rate hike until the last rate hike. We also exclude periods such as 1997 when the Fed only lifted rates once before reversing course. Table 1Corporate Bond Returns During Fed Rate Hike Cycles Our first preliminary conclusion is that (unlike with Treasury returns) there is not much commonality between the different cycles. For example, corporate excess returns were quite strong during the 2015-18 cycle and very weak during the 1999-2000 cycle. In other words, it’s even more important to examine each cycle individually to get a sense of how we should position in the corporate bond market today. The 2015-2018 Cycle The most recent Fed tightening cycle started with a 25 basis point rate hike in December 2015. The Fed then went on hold for 12 months before delivering a string of 8 hikes between December 2016 and December 2018. All in all, the tightening cycle lasted 36 months and the Fed raised the target rate by 225 bps. Investment grade corporate bond returns were quite strong during this period (Chart 1A), and there is one major reason why. The start of the tightening cycle happened to coincide with the peak of a default cycle. As a result, corporate spreads were elevated when hiking began and they tightened rapidly throughout 2016 and 2017 (Chart 1A, panel 3). Spread tightening in 2016 and 2017 was helped along by an accommodative policy environment, as evidenced by the fact that the yield curve remained steep (3/10 slope > 50 bps) during those years (Chart 1A, panel 4). It’s notable that returns turned negative in 2018, only after the average index spread moved below 100 bps and the Treasury slope moved below 50 bps. In other words, corporate bond returns were strong early in the cycle but turned negative once value evaporated and the monetary backdrop became less accommodative. High-Yield returns show a similar pattern to investment grade (Chart 1B). Spreads started out very wide in early-2016 and tightened rapidly until monetary conditions turned more restrictive in 2018. Our Default-Adjusted Spread is an additional valuation tool for high-yield bonds (Chart 1B, panel 4). This is calculated as the average index spread less the actual default losses that were experienced during the subsequent 12 months. Our research has shown that high-yield bonds usually outperform Treasuries during 12 month periods in which the Default-Adjusted Spread is above 100 bps (see the Appendix of this report for more details). In this case, the Default-Adjusted Spread was an extremely high 258 bps at the beginning of the tightening cycle and it didn’t dip below 100 bps until after rate hikes ended. Chart 1A2015-2018 Cycle: Investment Grade Chart 1B2015-2018 Cycle: High-Yield   The 2004-2006 Cycle During this cycle, which spanned from June 2004 to June 2006, the Fed lifted rates by 400 bps (sixteen 25 basis point rate hikes). The fed funds rate rose from 1% to 5.25% during the two-year span. Excess investment grade corporate bond returns were close to zero during this cycle (Chart 2A). Unlike in 2015, corporate spreads started out at tight levels (below 100 bps), though the accommodative monetary environment – as evidenced by the steep yield curve – allowed them to tighten somewhat during the first year of Fed hiking. However, spreads then reverted closer to 100 bps in 2005 as the yield curve flattened to below 50 bps (Chart 2A, panel 4) and the policy backdrop turned more restrictive. Junk bonds performed extremely well during the 2004-06 cycle (Chart 2B), and once again this is due to very attractive starting valuations. The average High-Yield Index spread was 384 bps on the day of the first hike in 2004, compensation that turned out to be astoundingly high when you consider that monthly default events were in the low single digits throughout the entire period (Chart 2B, bottom panel). As was the case in the 2015-18 cycle, our Default-Adjusted Spread measure never dipped below 100 bps. In fact, it troughed at 145 bps in early 2005 (Chart 2B, panel 4). Chart 2A2004-2006 Cycle: Investment Grade Chart 2B2004-2006 Cycle: High-Yield The 1999-2000 Cycle In this cycle, the Fed lifted rates by 175 bps between June 1999 and May 2000, driving the fed funds rate from 4.75% to 6.5%. Excess investment grade corporate bond returns were poor during this period (Chart 3A), the combination of relatively low starting spreads and a very flat yield curve that even inverted in early 2000 (Chart 3A, panels 3 & 4). High-yield excess returns were even worse than for investment grade (Chart 3B). While, at the onset of Fed tightening, junk spreads were quite elevated in absolute terms (Chart 3B, panel 3), they turned out to be too low compared to the magnitude of default losses that occurred throughout 1999 and 2000 (Chart 3B, bottom panel). Our Default-Adjusted Spread measure started the cycle below 100 bps and then dipped into negative territory in early 2000 (Chart 3B, panel 4). Chart 3A1999-2000 Cycle: Investment Grade Chart 3B1999-2000 Cycle: High-Yield The 1994-1995 Cycle The Fed surprised markets by lifting rates extremely quickly during this cycle. The Fed moved rates from 3% to 6% in the span of only 12 months between February 1994 and February 1995. This cycle coincided with modestly positive excess returns for investment grade corporates (Chart 4A). The average index spread began the cycle at the extraordinarily tight level of 67 bps (Chart 4A, panel 3). However, unappealing valuations were counteracted by the accommodative monetary environment, as evidenced by a yield curve slope that didn’t dip below 50 bps until the Fed was almost done hiking (Chart 4A, panel 4).    Junk returns were also modestly positive during this period (Chart 4B). Spreads started the cycle at attractive levels (Chart 4B, panel 3) and the default rate was on the downswing (Chart 4B, bottom panel). Junk spreads, however, were mostly rangebound during the period of Fed tightening. Chart 4A1994-1995 Cycle: Investment Grade Chart 4B1994-1995 Cycle: High-Yield Investment Implications Investment Grade Our analysis of past cycles reveals that valuation and the slope of the yield curve are the two most important factors to consider when assessing the potential for investment grade corporate bond excess returns during a Fed tightening cycle. The 2015-18 period of strong investment grade returns coincided with elevated spreads and a yield curve slope that stayed above 50 bps for the first two years of tightening. In contrast, the 1999-2000 period of negative corporate returns was driven by expensive starting valuations and a very flat curve. Today, investment grade corporate bond valuations are about as expensive as they’ve ever been. The average index option-adjusted spread (OAS) is currently 100 bps, the index OAS has been tighter than this level 40% of the time since 1995 (Chart 5). This does not appear terrible at first blush, but we must also consider that the risk characteristics of the index have changed during the past few decades. Specifically, the index’s average credit rating is lower, and its average duration is higher. If we adjust the index to maintain a constant credit rating through time, we see that the spread falls from its 40th percentile to its 28th percentile (Chart 5, panel 2). If we then adjust for the changing duration of the index by looking at the 12-month breakeven spread instead of the OAS, we see the spread fall to its 7th percentile since 1995 (Chart 5, bottom panel).3 As for the yield curve, the 3-year/10-year Treasury slope is currently very close to 50 bps – the threshold that roughly represents the transition from an accommodative monetary environment to a more neutral one (Chart 6). Given expensive starting valuations, our inclination is to reduce our investment grade corporate bond exposure once we are confident that the 3/10 slope will remain below 50 bps for the remainder of the cycle. We think we are close to reaching that point, but we aren’t quite there yet. Our estimates based on a range of plausible scenarios for Fed tightening suggest that the 3/10 slope will permanently move below 50 bps in the coming months, by July at the very latest. When that occurs, we will reduce our recommended corporate bond exposure from neutral (3 out of 5) to underweight (2 out of 5). Chart 6Watch The Treasury Slope Chart 5IG Valuation High-Yield The valuation picture for high-yield is somewhat more pleasant than for investment grade. The OAS differential between the high-yield and investment grade indexes is fairly tight, at its 15th percentile since 1995 (Chart 7). However, this differential rises to the 36th percentile when we adjust for the duration differences of the indexes by using the 12-month breakeven spread. Chart 7HY Valuation Applying our Default-Adjusted Spread methodology to today’s junk market, we estimate that the Default-Adjusted Spread will come in above the crucial 100 bps threshold as long as the default rate is 3.5% or lower during the next 12 months (Chart 7, bottom panel). This seems quite likely given the current strong state of corporate balance sheets.4 All that said, the evidence from past cycles suggests that a more defensive posture toward high-yield corporates will also be warranted once we are confident that the 3/10 slope has permanently moved below 50 bps. However, relative valuation dictates that we should still retain a preference for high-yield over investment grade even as we get more defensive overall. Our next move will likely be to downgrade high-yield from overweight (4 out of 5) to neutral (3 out of 5). Some Thoughts On Credit Investment Strategy The above analysis of corporate bond performance shows that it is generally weaker once the yield curve has flattened into a range of 0 – 50 bps. However, that move alone doesn’t guarantee negative excess corporate bond returns. In fact, it is quite plausible that the slope could remain within a 0 – 50 bps range for a long time even as the Fed tightens, and that corporate bonds could still deliver small positive excess returns versus Treasuries. However, we must acknowledge that the risks of Fed overtightening, curve inversion and economic recession increase as the yield curve flattens. We must also acknowledge that current valuations suggest that future excess returns will be small, even if they are positive. For example, if we assume that the average investment grade OAS can’t tighten very much from current levels, then the best we can expect is 100 bps per year of excess return. Meanwhile, 100 bps of spread widening – much less than you would expect in a default cycle – would lead to losses of roughly 850 bps. In other words, it will be profitable to exit investment grade corporate bond positions today as long as the next bout of 100 bps of spread widening occurs within the next 8.5 years (Table 2). The risk/reward trade-off clearly favors a more defensive credit allocation. Table 2The Risk/Reward Trade-off In Corporate Bonds Interestingly, Table 2 shows that the risk/reward math is more favorable for junk bonds. Depending on our default loss assumptions, the 8.5 years we calculated for investment grade falls to a range of 1.8 to 3 years for high-yield. Bottom Line: Tight valuations and low expected returns suggest that investors should be more cautious on credit risk this cycle. In our view, it is advisable to reduce credit risk allocation earlier than usual this cycle in order to ensure that you aren’t invested during the next big selloff. Appendix Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Positioning For Rate Hikes In The Treasury Market”, dated January 18, 2022. 2 We define excess returns as the excess returns earned by the corporate bond index relative to a duration-matched position in US Treasuries. 3 The 12-month breakeven spread can be thought of as the spread widening required for the index to break even with duration-matched Treasuries on a 12-month investment horizon. It can be approximated as OAS divided by duration. 4 Please see US Bond Strategy Weekly Report, “The Fed’s Inflation Problem”, dated November 23, 2021. Recommended Portfolio Specification Other Recommendations Treasury Index Returns Spread Product Returns