As the Federal Reserve makes patience its new watchword against a backdrop of swirling economic concerns, analysts at Bank of America Merrill Lynch say investment-grade corporate bonds will catch-up with stocks.
“Macro uncertainties holding back equities are also holding back the Fed — a much better trade-off for [investment-grade] credit,” wrote Hans Mikkelsen, head of high-grade credit strategy at Bank of America Merrill Lynch, in a note on Monday.
In the long-run, stocks outperform high-grade debt handily. But an investing environment marked by fewer rate hikes but modest growth could see investment-grade credit beat riskier assets like high-yield debt and stocks.
The Fed, which will conclude a two-day policy meeting on Wednesday, is expected to pursue a more cautious approach to rate increases as it waits to see how the U.S. economy negotiates stumbling blocks including trade tensions and slower global growth. Fears the Fed was moving too fast to raise rates were blamed for a late-2018 selloff, while a subsequent January rebound has been tied to pledges to take a more patient approach.
Read: Fed to stress patience and that means no interest-rate move until at least June
But lingering worries over the global growth outlook pressured U.S. equities on Monday after a raft of companies blamed weak earnings on China.
See: 3 ways China’s pain could slam the brakes on global economic growth
Also read: These U.S. companies are surprisingly bullish on China
To Mikkelsen, the high-grade corporate debt index’s relative outperformance against stocks on Monday and last week demonstrated how both assets “are once again in the process of converging — this time as risks are priced out of the credit market.”
The S&P 500 SPX, -0.06% Dow Jones Industrial Average DJIA, +0.36% Nasdaq COMP, -0.63% finished lower on Monday, whereas the yield premium for high-grade corporate debt over Treasurys TMUBMUSD10Y, -1.05% a measure of investor appetite for such bonds, held steady at 1.4 percentage points. And last week, yields for high-grade bonds fell, compressing credit spreads by around 5 basis points, even as stocks ended mostly flat for the week. Bond prices move in the opposite direction of yields.
To be sure, the outperformance has been limited to the past few trading sessions.
Over the course of January, stocks have enjoyed a clear lead. Returns for investment-grade corporate bonds stand at around 1.3% month-to-date, while the broad-based S&P was up by around 5.5% over the same period. That leaves investment-grade corporate debt with plenty of ground to make up.
Still, Mikkelsen says other factors could help make his wager successful. After several weeks of sustained outflows, investors have begun to trickle back in to investment-grade debt. Last week, net buying of high-grade corporate debt rose to $1.3 billion from $600 million the previous week, EPFR Global data showed.
And the BAML strategist said investment-grade debt will also reap stronger returns as broker-dealers top up their depleted inventories of corporate bonds after the recent months of market turbulence dissuaded them from trading fixed-income securities.
Dealer positions for high-grade corporate debt stood at a net long of $15 billion as of Jan. 16, compared with its more sizable positions in U.S. government paper at $226 billion, according to Jefferies.