‘There doesn't seem to be any excessive leverage in them and so it feels like a safe place to put the money right now,’ says MFS’ Soami Kohly
Each month at BPM, we offer a slate of articles and content pieces that go deep on a particular topic. This month, we're exploring fixed income as an asset class and the critical components that make up institutional portfolios.
With all-in yields still at levels that satisfy return targets, strong corporate balance sheets, and governments running up fiscal deficits that make some bondholders nervous, corporate bonds are grabbing fixed income investors' attention.
As a result, the traditional hierarchy between government and corporate debt is getting a second look.
"There's been a lot of demand for corporate bonds,” said Sam Acton, co-head of fixed income at PICTON Investments. “The all-in yield you can get on a high-quality corporate bond is still attractive. It's at a level where high net worth individuals, pension funds, life insurance companies, they can put money to work and feel like they're achieving their investment return targets in a fairly safe place. They're willing to accept a smaller credit spread because the all-in yield is still at an acceptable level for them.”
Soami Kohly, investment officer and fixed income portfolio manager with MFS Investment Management, breaks corporate bonds into their two basic components: the underlying government bond yield and the spread investors earn for lending to corporations. That spread has compressed sharply, approaching levels not seen since before 2005.
"Corporate spreads have come into almost those levels, the index level getting probably high 70s by the end of last year, or definitely by the beginning of this year," he said, noting that tightening has worked the same way falling interest rates do, driving strong outperformance for corporate bonds.
Over time, he expects investment grade corporates to beat government bonds on a like-for-like duration basis. Risk assets tend to outperform safe assets, and while there will be stretches of underperformance when spreads widen, the higher yield corporate bonds carry is the main engine of returns over the long run. Kohly also points to the health of corporate balance sheets as a reason to stay comfortable with the asset class.
"There doesn't seem to be any excessive leverage in them and so it feels like a safe place to put the money right now," he added.
According to Kohly, the traditional crisis playbook, where government bond yields rally, the US dollar strengthens, corporate spreads widen, equities sell off, hasn’t played out the way most investors would expect in most recent market moves. Corporate spreads did widen slightly and equities dipped before recovering, but government bond yields failed to rally.
He reads that as a signal on two fronts. First, inflation anxiety is back, driven by higher oil prices, and investors are more sensitive to that risk now than they would have been five years ago given what markets went through recently. He draws a parallel to the first Gulf War, when yields initially sold off before the economy tipped into recession and yields eventually fell.
Second, Kohly interprets the bond market's muted reaction as a sign that markets do not see the current situation as recessionary. If that reading is correct, then government bond yields have no reason to rally because there is no expectation of slowing growth or central bank rate cuts. And if the bond market is right, then the equity market is right too so corporate earnings should hold up, he noted.
Acton believes the pressure on government bonds is tied to a post-COVID pattern of widening fiscal deficits rather than any sudden recent shift. He noted how governments across major markets are spending more and issuing more debt to cover that spending, whether for defence, stimulus, tax cuts, or other policy choices.
From an investor’s standpoint, that raises doubts about how long this can continue as bondholders are increasingly questioning the sustainability of running deficits at these levels for another five or 10 years, and that eventually governments will have to “bring that back more into balance,” he said.
For Acton, the issue comes back to inflation and the way markets behaved in 2022, when rising prices pushed stocks and bonds in the same direction instead of allowing bonds to act as a buffer. He sees a similar pattern now as conflict in Iran and higher oil prices revive fears that inflation could flare up again. That concern is also feeding into central bank thinking and pushing bond yields higher, which in turn is weakening the usual diversification benefit government bonds are supposed to provide when equities come under pressure.
“It comes back to the fiscal deficits and at some point, investors do start putting a slight risk premium on what is classically considered a risk-free asset,” he noted. “But when governments are not making conservative financial decisions with their balance sheets, investors maybe do prefer a very strong AA-rated corporate, even though governments still have taxing authority over them. As people maybe put a little bit of that risk premium or build a steeper curve in for governments, maybe they do feel more comfortable in that corporate world.”
Acton also flags a notable trend in new corporate bond issuance, noting the AI buildout has turned tech giants like Microsoft, Amazon, Google, Meta, and Oracle into some of the largest borrowers in the corporate bond market, a sharp reversal from prior years when these companies were heavy cash flow generators funnelling capital into share buybacks.
"Now, all of a sudden, they're the biggest bond issuers because they have such a larger Capex program with this AI build out," he said, adding these companies aren’t limiting themselves to US dollar debt either, tapping euro, gilt, and other global bond markets as well.
While Kohly doesn’t think investors need to rethink their fundamental approach to government bonds, he frames the question as really about one's economic outlook, noting emphasizing that investors who believe growth is about to slow should be buying government bonds, which have only gotten cheaper.
“If we have a recession or a slowdown in economic growth, you still want to own government bonds and that's Canada, that can be US and obviously globally. The talk appears to be about maybe not as buying as much US but still US. I always expect Treasury yields to rally if we had an economic slowdown,” said Kohly.
