Tuesday, November 28, 2023
November has been a good month for bond bulls with returns for most fixed income categories (so far) posting solid returns. However, despite the solid returns recently, fixed income volatility remains high and longer-term trailing returns are negative for many of the core bond categories. That could raise the question about ongoing demand for bonds. However, with starting yields still among the highest levels in years, investment grade corporate bonds, in particular, are extremely attractive to yield buyers like pension funds and insurance companies.
The investment grade corporate buyer base can generally be broken into three segments: A) domestic institutional investors, B) domestic retail funds and C) foreign investors. According to JPMorgan, those segments are roughly 45%, 26% and 29%, respectively. And within the domestic institutional investor segment resides pension fund investors who have traditionally cared more about total yields than spreads (or the additional compensation for owning riskier debt). And this segment could be a large buyer of corporate bonds for years to come as the funding status of these plans has improved.
The Milliman 100 Pension Funding Index chart below shows pensions, in aggregate, are overfunded (104.2% of target), which means the value of their assets are currently more than their liabilities. Prior to 2022, pension funds were generally underfunded so to help fill those deficits, plans were generally overweight equities. In theory, fully funded pension plans de-risk portfolios by selling equities and buying bonds to lock in a more certain return stream and to lock in higher yields that can be used to offset/cover future liabilities. So now that plans are running surpluses, pension investors have been net sellers of equities and buyers of corporate bonds, which has helped support prices.
Demand for these higher yields comes at a time when high grade corporate bond issuance remains muted. Many corporations termed out debt in 2020, i.e., they issued a lot of debt at very low interest rates for long maturities. As such, high grade corporations, in general, don’t need to access the capital markets anytime soon (2025 will be a large year for maturities). Thus, supply of new bonds remains below historical averages.
As such, positive demand to go along with muted supply should provide stability for prices within the category. While our preference has been to stay in the short-to-intermediate parts of the corporate credit universe, with the Federal Reserve likely done raising rates, extending duration and locking in high yields for longer may make sense for those investors with longer time horizons.
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