Higher Yields, Headwinds for Stocks Make 2023 Year of the Bond

(Bloomberg Businessweek) -- Investors found few places to hide from last year’s demolition derby, which hit corporate bonds harder than it did stocks on a global basis. But if Wall Street’s credit managers and prognosticators are right, 2023 will be the year that corporate bonds boom.

Despite a late-year rally, the value of corporate debt declined worldwide in 2022 by $2.6 trillion, or nearly 17%, according to Bloomberg data. Blue-chip corporate debt had the worst year on record after a similar fall. By comparison, stocks fell 13.7%.

One reason bonds are poised for a rebound is that debt is looking more attractive than equity. The 2022 swoon means investors can buy bonds at big discounts to last year’s values, with the average low-risk corporate bond priced at about 90 cents on the dollar. Less than two years ago, they traded at 110 cents on the dollar.

As the economy weakens, companies with high credit ratings will use spare cash to reduce their debt rather than buy back stock, Bank of America Corp. strategists say, which is a positive for holders of those bonds. The prospect of an economic slump, which means lower corporate profits, dims the outlook for stocks. And if recession pushes riskier companies into bankruptcy, shareholders could be wiped out, while bondholders typically recover at least part of their investment.

All these possibilities have Swiss wealth manager UBS Group AG predicting a “once-in-a-decade opportunity” in credit. Bank of America strategists are forecasting a total return—mainly price appreciation plus interest—of 9% from high-grade US company debt this year.

That’s not to say there aren’t risks. Although the Federal Reserve is signaling that rate hikes are ending, there’s no guarantee it will conclude that inflation is finally licked. Further increases could trigger or deepen a recession, potentially pushing heavily indebted companies into default.

With consumer spending set to slow, it will be difficult for some companies whose credit ratings are below investment grade “to generate cash in the first half,” says Mike Scott, a portfolio manager at investment company Man GLG in London.

But fund managers prefer to focus on the dramatic turnaround in bond yields. The end of cheap money means the safest companies now generate higher yields than junk bonds did at the start of last year, allowing investors to pick up decent returns while avoiding riskier assets. Blue-chip bonds globally are yielding 5.1%, while junk bonds were at 4.85% 12 months ago. That’s a boon for pension funds in particular. During the quantitative easing era—when central banks purchased bonds to keep interest rates low and stimulate the economy—retirement plans had to look elsewhere for yield and invested in everything from a makeover of Amsterdam’s red-light district to superyacht marinas.

Higher interest rates have already resulted in many pension plans rotating out of equities and into bonds. “On a yield basis, if you look back over 22 years, US credit’s cheap,” says Matthew Rees, head of global bond strategies at Legal & General Investment Management Ltd. in London. “That’s why flows have come in again.” In Europe high-grade funds ended the year with 10 consecutive weeks of inflows, a trend that’s expected to spread to the US.

Companies are also ready to take advantage of the increased demand for debt, with as much as $58 billion of US bond sales completed in the first week of January, a huge rebound in volume after the worst December in at least 15 years.

“It’s going to be leading to significant inflows” of money into the market, says Matt Brill, head of North America investment-grade credit at Invesco Ltd. “Investors have waited a long time for these higher levels of yields.”

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