Investors are nervous. In a recent JPMorgan survey,1 the bank highlighted that investment-grade (IG) credit would likely face several headwinds through the end of the year due to increased supply, less-favorable fundamentals and noise from the midterm elections. In our view, a straightforward way to combat these challenges is by taking a fundamental approach and increasing positions in the short end of the yield curve. Below, we highlight these headwinds and then illustrate why we believe the WisdomTree Fundamental U.S. Short-Term Corporate Bond Fund (SFIG) can be a powerful tool in navigating tricky markets.
Supply
In an earlier blog post, we highlighted the impact that increases in supply can have on corporate bond spreads. In classic Econ 101, if supply increases, then prices must decrease. In the bond market, lower prices are synonymous with higher yields. When supply increases and demand stays the same, borrowers may be forced to pay up to issue new debt. As this happens, the broader market tends to underperform.
In their report, JPMorgan expects an additional $340 billion in borrowing through the end of the year with nearly $100 billion being raised to finance M&A activity. With the majority of benchmark IG issuance occurring in the 10- and 30-year sector, it’s likely that credit spreads will need to widen to absorb this new supply. However, at the short end of the curve, spreads tend to be much more driven by economic fundamentals. For this reason, we believe that investors concerned about the relationship between credit spreads and issuance should bias their portfolio to the shorter end. As we show in the chart below, longer maturity issues tend to average about 50 basis points (bps) of additional spread compared with shorter-maturity fixed income. This is driven by a few factors, most notably that the longer the tenor, the more compensation an investor will demand because of uncertainty. For an IG issuer, it’s extremely unlikely that their business will experience a shock that would threaten their ability to pay you back in the short run. Over 10 or even 30 years, the fundamentals of their business evolve along with the business cycle. For this reason, the credit curve tends to be upward sloping.
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