The Long and Short
Year-to-date returns as midyear approaches
This material is a Marketing Communication and does not constitute Independent Investment Research.
Yield spreads on the investment grade corporate bond index are hovering near the historic tights first established in January this year. A quick temperature check as mid-year approaches puts some context on current spread valuations. There are some opportunities in specific areas that could have more room to run if investors continue to maintain their risk-on posture in the face of geopolitical and private credit uncertainty.
Investment grade corporates provided total return of 0.72% in the first roughly six months of the year with an equally modest excess return (credit return net of treasuries) of 0.74%. On that basis, corporates outperformed all broad securitized lending categories (ABS, MBS, CMBS) in the first half of the year but are falling short of excess returns in both the high yield market and emerging markets (Exhibit 1). The investment grade index hit its historically tight level of 71 bp OAS in late January, before peaking at 93 on March 16 at the height of Iran conflict dislocation, only to travel roundtrip to its current valuation of about 73 bp. This has relegated performance in the sector to largely a modest carry trade year-to-date comprising the bulk of total returns.
Exhibit 1: Broad fixed income performances year-to-date
Source: Santander US Capital Markets LLC, Bloomberg fixed income indices
Within fixed income subgroup categories, investment grade industrial (0.84%) and utility (0.86%) credits have delivered Top 5 excess return performances, with financials (0.51%) lagging all but the consumer ABS categories and high yield financials. Latam (3.11%) has been far and away the most rewarding trade in fixed income credit, trailed by the high yield utility (1.77%) and industrial (1.31%) categories.
Exhibit 2: Broad fixed income subgroup performances year-to-date
Source: Santander US Capital Markets LLC, Bloomberg fixed income indices
Within the investment grade index (Exhibit 2), the sectors that outperformed over this period were not surprisingly energy (1.68%) and basic materials (1.40%), with strong performances from transports (1.02%) and natural gas (0.96%) as well. Mostly financials rounded out the bottom of the spectrum, with banking (0.42%), brokers (0.45%) and finance companies (0.54%) among the bottom five performing segments of the index. Communications and cyclicals were also among the bottom performances, though the former saw idiosyncratic circumstances on large index constituents (specifically, fallen angel PARA) that vastly influenced performance in the first half of the year.
Exhibit 3: Investment grade sector performances year-to-date
Source: Santander US Capital Markets LLC, Bloomberg fixed income indices
Percentile rankings can usually serve as a rich/cheap analytic based on historical trading levels. Current OAS for a given sector generates a percentage of the 5-year trading ranges allowing for quick comparisons relative to where the broad index is currently valued (Exhibit 4). On that basis, most segments within the investment grade market offer extremely limited room for spreads to compress further and generate excess returns (left side of the grid). However, some of the sectors still provide upside within their historical trading ranges, albeit on a limited basis with spreads bumping up against the all-time tights (right side of the grid). Not surprisingly, finance companies (which are mostly BDCs at this point) remains at the top of the list. The 48% 5-year percentile ranking is somewhat misleading as BDC issuance in the segment did not really ramp up until 2024, and spreads traded at extremely wide levels before that market began to mature. Tech (44%) is largely reflective of supply technicals, while brokers (19%) still have a degree of the private credit selloff that drove valuation year-to-date.
Exhibit 4: Investment grade sectors current 5-year spread percentile rank
Source: Santander US Capital Markets LLC, Bloomberg fixed income indices
Drilling a layer deeper to the index subsector level provides a more detailed landscape of where opportunity might lie within the investment grade market (exhibit 5). But taking into consideration the available opportunity set in each subsector, much of the market appears priced to perfection even as the conflict in Iran stretches on with no viable timeline for a potential ceasefire.
Exhibit 5: Investment grade non-financial sub sectors 5-year spread percentile rank
Source: Santander US Capital Markets LLC, Bloomberg fixed income indices
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