By T. Rowe Price | May 18, 2022
Kenneth A. Orchard, Portfolio Manager
Onur Uncu, Quantitative Analyst
Originally published March 30, 2022

Inflation is proving to be sticky, which puts pressure on central banks to tighten policy. Kenneth Orchard is a Portfolio Manager at T. Rowe Price for the Canada Life Global Multi-Sector Fixed Income Fund. Together with analyst Onur Uncu, they consider the impact of policy tightening on corporate bonds and how portfolio managers may be able to boost performance in the period ahead.

Russia’s invasion of Ukraine has injected a heavy dose of uncertainty into the global economic outlook, but this month the U.S. Federal Reserve (Fed) stuck to its plan to raise interest rates for the first time since 2018. Given the likely inflationary impact of the war, the Fed looks set to continue on its tightening path for the remainder of the year. For investors, then, the challenge of how to position their portfolios for a rising rate environment remains a pressing one.

The Fed’s determination to tighten financial conditions is hardly surprising. Stubborn inflationary trends caused by post‑pandemic easy monetary policy, supply chain disruptions, and rising energy prices have been a source of anxiety in markets for some time. Looming inflation puts pressure on central banks to tighten policy, which causes trouble for credit investors in two ways: first, rising bond yields have typically hit corporate bonds hard because of the duration embedded within them; and second, corporate bond spreads tend to be adversely affected by tighter financial conditions. In this article, we’ll focus on the latter.

Higher policy rates generally make corporate borrowing more expensive as investors demand a premium over the policy rate when they lend to corporates. Rising borrowing costs eat into corporate profits, which is negative for corporate bond spreads.

Not all corporate bonds are equal, though. Monetary policy tends to normalize in the long term as growth slows and/or inflation subsides. Aware of this, the markets tend to price in the fact that shorter‑term bonds will be heavily exposed to short‑term risks while longer‑dated bonds will likely benefit from a normalization of conditions. This is evidenced by the fact that, historically, the Sharpe ratios (a measure of risk‑adjusted returns) of longer‑dated U.S. investment‑grade (IG) corporate bonds have been higher than shorter‑dated IG bonds when yields rose (Figure 1). This suggests that credit investors may be able to boost performance in the period ahead by allocating more to longer‑dated credit.

Longer‑dated U.S. IG credit has outperformed during periods of rising yields 

Figure 1: Markets have typically priced in the normalization of policy in the long term 

As of February 28, 2022.
Past performance is not a reliable indicator of future performance.
Based on monthly credit excess returns data between January 2000 and February 2022.
Tenor refers to the time remaining until the end of a bond’s contract. We take monthly credit excess returns for each of the four tenors above. For each month, we calculate the change in the U.S. 10‑year rate. We then take the subset of the months where the U.S. 10-year rate has gone up. On that subset, we calculate the annualized excess returns and volatility for each tenor. Sharpe ratio is calculated as the ratio of annualized excess returns divided by annualized excess return volatility.
Sources: Bloomberg Indices, Bloomberg Finance L.P.

It’s worth noting that the current tightening conditions differ from previous ones in a way that spells more risk for corporate bond spreads. Over the past 40 years, the Fed’s main goal with tightening has been to slow growth and prevent economic overheating; this time, it is trying to control inflation. This means that unless inflation falls back, the Fed is likely to continue tightening, even if growth is weaker than during previous tightening periods, which would hit shorter‑term credit harder than longer‑dated credit. An extended war in Ukraine could exacerbate this still further given that wars are invariably inflationary.

Positioning at the long end of the credit curve has the additional benefit of being cash‑efficient. Long‑dated bonds tend to have higher “duration times spread” (a measure of the credit volatility of a corporate bond) per dollar invested. This means that a target risk level can typically be achieved with a smaller cash outlay. Allocating to longer‑dated corporate bonds, therefore, should allow investors to unlock cash that may then be used in other ways to generate yields, such as purchasing Treasury inflation protected securities (TIPS).