Assessing U.S. Investment Grade Debt

By George Bory and Scott Smith

Scott Smith, head of the Investment Grade Income team at Allspring Global Investments, speaks with George Bory, chief investment strategist for Fixed Income, about inflation, rates, credit spreads, and the economic outlook from the Investment Grade Income team’s perspective.

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George Bory: I’m George Bory, chief investment strategist for Fixed Income at Allspring Global Investments, and you’re listening to On the Trading Desk®. Today we’re having a conversation on assessing U.S. investment grade debt. And joining me is Scott Smith. Scott is head of the Investment Grade Income team at Allspring Global Investments and he’ll talk about what’s happening in fixed income and, specifically, what’s happening in the U.S. investment grade market. Scott, thanks so much for being on the show.

Scott Smith: Thanks for having me, George, glad to be here.

George: To begin our conversation. Inflation is everywhere and always a monetary phenomenon. You head up the Investment Grade Income team. So, some of the big questions right now are around what’s your team’s view on inflation, specifically, the Federal Reserve, as we head into year end.

Scott: Our view on inflation, I’m going to go out on a limb and say that inflation has peaked now for the cycle and should be trending lower here. I mean, in particular, I think we’re getting some help from commodities in general, energy, specifically, and food. So, all of this should start feeding into the numbers near term. But back to the Fed (Federal Reserve), regardless, we still have a long way to go on the inflation front. The Fed is going to continue to move us nicely into restrictive territory. I think we should take the Fed at its word with its terminal Fed funds pegged at 4.5%. We think they go there and they stay there for a very long period, for a minimum of 9 months, up to 18 months.

George: The financial markets seem like they’re trying to price in a recession, begrudgingly. What’s your team’s view on the economic outlook?

Scott: Clearly, at some point, the narrative will move away from this historically high inflation to one of a slowing economy. As the slowdown broadens throughout the economy, we expect this narrative to become much more pervasive, but it’s probably not till the first quarter of 2023 that that really takes hold and allows rates to stabilize and move lower from here.

George: What’s your read on rates? And then the secondary question is credit spreads.

Scott: I think you really have to start with this notion of where terminal Fed funds is going to end up. We believe that 4.5% is the right rate. It’ll take a while for this to work its way through, but if 4.5% is the terminal Fed funds rate, then we have already priced a lot of this into the termed-out interest rate complex. That is not to say we will not continue to see rate volatility as we work through this inflation data. And the other thing, just to keep in mind is just the difference between the long end and the short end of the yield curve. We think the long end is going to increasingly be responsive to the slowdown in the economy. So, all this implies a deeper inversion in the yield curve. All of this narrative for us is just highlighting that the bulk of the rate move is likely behind us. I think implications for portfolios is that you should be comfortable now extending a little bit, in particular, if you’ve been short. Credit spreads are definitely becoming more interesting. My caveat is just that the Fed is still in motion. We still have around 150 basis points of rate rises yet to come. We believe that corporate earnings will continue to get guided lower. The note I would make is that the risk reward characteristics for the market in general have become much more balanced. And so, there’s just a lot more cushion and a lot more yield support for the markets in general.

George: One final question for you Scott, are clients responsive to this? Are clients saying, “Hey, this is a great time?” What kind of feedback are you getting from clients when you have these conversations?

Scott: I mean, it’s obviously it’s been an extraordinarily difficult year, historically bad year in fixed income. But I do think people are kind of looking powerfully forward, especially liability-based mandates, insurance companies. And so, we’re seeing a lot more inquiry in that regard. I mean, there’s just a number of very compelling micro themes playing out in the market. And the front end of the credit curve is very interesting with the inversion. So, just by one example, you can buy 3-year single-A banks supported by very sound fundamentals at about 5.5%. So just mathematically, spreads would need to widen by over 2% before you would have a negative return on that. So that would then need to go to 7.5% before you would start to generate a negative return. And so, this is really where I’m going about the risk/reward characteristics being much more balanced. And to your point, clients are absolutely responding to this new dynamic and this new yield support in the market.

George: Scott, really appreciate you taking time today to talk about the market, given all the volatility of this year and price volatility and spread volatility. It is good to hear that the valuations look attractive, that we could be close to the top in terms of yields. And while spread volatility might be high, the breakeven and the cushion looks very attractive. So, thank you very much for your insights and really appreciate you being On the Trading Desk today.

Scott: Thanks, George. Happy to participate.

George: That wraps up this episode of On the Trading Desk. If you would like to read more market insights and investment perspectives from Allspring Global Investments, you can find them on the firm’s website, allspringglobal.com. To stay connected to On the Trading Desk® and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Spotify, Google Podcasts, or whatever podcast subscription service you use. Until next time, I’m George Bory. Thanks for listening.

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Originally Posted October 17, 2022 – Assessing U.S. Investment Grade Debt

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