The U.S. Federal Reserve (Fed) has finally joined other major central banks in cutting interest rates. After a long wait, and heightened focus on yield available in the front end of the curve, insurance investors are now concerned they may have left it too late to get the yield needed into portfolios to close their duration gaps.
We think this concern is somewhat misplaced. Rates may be declining, but we do not believe we are going back to pre-pandemic lows. While credit spreads may be tight, all-in yields remain attractive, and even more so in several areas of private high-grade fixed income where investors can benefit from covenant and structural protections, diversification and a capital-efficient yield advantage. High-grade private placement debt, private residential whole loans and European private loans (European private placements) stand out as durable opportunities for eligible investors, in our view.
While we acknowledge the market consensus in favor of a soft landing in the U.S., the balance of the credit cycle has yet to play out, spreads are tight and we think they are likely to shift to compensate investors accordingly. Importantly, this could take time, and we think one of the best places for incremental capital is among high-quality, higher-yielding segments, sacrificing on liquidity, but not credit quality.
Rate Normalization
Following the Fed’s initial 50-basis-point rate cut in September, futures markets now anticipate that the central bank will reach its terminal rate, at around 3.5%, in just over a year’s time, according to FactSet. In addition, Treasury markets have steepened the U.S. yield curve and are likely to steepen it still further over the coming months. In Europe, we anticipate a similar move to a terminal central bank rate around 2.0 – 2.5%.
We regard this as a rate-normalization process: we think the Fed is targeting a neutral terminal rate rather than the accommodative rate one would associate with a sharp economic downturn. This would represent a substantial decline at the very front of the curve, but it would leave us a very long way from the flat, near-zero curves of the pandemic era and much of the period following the Global Financial Crisis. It suggests intermediate and long-dated U.S. Treasuries may still be yielding as much as 3.75 – 4.50%, even after the Fed has finished cutting rates.
Today, while investment grade credit spreads have tightened below the average of the past three years, this moderate projected path for rates has left investors with relatively attractive all-in investment grade credit yields.
While Investment Grade Spreads Have Tightened, Yields Remain Attractive
Global investment grade credit, option-adjusted spread
Global investment grade credit, yield to worst
Source: FactSet. Indices used: ICE BofA Global Corporate Index (1-5Y and 10+Y). Data as of October 4, 2024.
We currently see a relatively benign environment for credit, even in a more aggressive slowdown, owing to the way debt markets have termed out capital structures and taken pressure off refinancing needs over the next couple of years. This has been one of the fastest debt extensions in history, cutting the 2024 – 26 high-yield maturity wall by some 40%. As the table below shows, only 8% of the market is set to mature over the next two years, and less than a quarter of one percent of those maturing bonds are currently at stressed pricing below $70.
High-yield Bonds Generally Have Long Maturities, and Are Not Priced for Stress
Proportion of the high-yield market maturing in any given year, in total and segmented by current price
| 2025 | 2026 | 2027 | 2028 | 2029 | 2030+ | |
|---|---|---|---|---|---|---|
| Priced at < $70 | 0.05% | 0.24% | 0.28% | 0.37% | 0.79% | 0.95% |
| $70-$80 | 0.02% | 0.12% | 0.15% | 0.80% | 0.66% | 0.95% |
| $80-$90 | 0.00% | 0.72% | 0.76% | 0.75% | 1.48% | 4.26% |
| $90-$95 | 0.20% | 0.22% | 0.67% | 2.41% | 6.12% | 5.91% |
| $95-$100 | 0.59% | 5.11% | 7.02% | 6.31% | 7.04% | 4.75% |
| Priced at >$100 | 0.25% | 1.88% | 4.14% | 6.63% | 7.69% | 19.93% |
| TOTAL | 1.12% | 8.29% | 13.03% | 17.26% | 23.79% | 36.51% |
Source: Neuberger Berman, Aladdin. Data as of August 30, 2024. Index used: ICE BofA U.S. Hjgh Yield Index.
In addition, much of the more highly leveraged LBO and M&A activity is shifting from leveraged loans to private credit markets. The proportion of the high-yield bond market with the highest, BB quality profile, is at a record level. Our cumulative default rate projected for 2024 and 2025 is 5.5 – 6.0%, in line with the 2.8% realized default rate in 2023—and the problem sectors, including Telecoms, Healthcare and Cable & Media, are reasonably well known.1
Low Leverage, Security, Covenants and Structural Protections
That said, the other thing the table above shows is that a very large proportion of the high-yield market is priced above $95. At this stage in the cycle, and at these valuations—even in an unusually benign downturn for credit—we would not suggest pushing out on the credit spectrum for more spread and yield.
Instead, we see more attractive opportunities in several key areas of the private fixed income market, which generally are characterized by relatively low leverage, security against real assets or cash flows, and the kind of covenants and structural protections that are increasingly rare in the public markets.
A Selection of Private Credit Markets and Their Typical Spreads Over Comparable Private Securities
Source: As of September, 2024. 1. Source: Bank of America Securities and Neuberger Berman. 2. Source: Private Placement Monitor. 3. Source: EPL sourcing banks and Neuberger Berman. 4. Source: Neuberger Berman, FactSet; spread shown is over the ICE BofA Global Corporate Index yield. Estimated equivalent credit rating. For illustrative purposes only. Historical trends do not imply, forecast or guarantee future results. Asset class spread and yield ranges are not intended to represent or imply any projected return and are not indicative of any portfolio, product or strategy.
In our view, these asset classes fit neatly into existing insurance investors’ investment grade portfolios whether they are seeking to cover short-tail Property and Casualty risks or longer Life and Annuity liabilities. The quality, duration and diversifying characteristics make all of them relatively capital-efficient. Less trading also means they tend to exhibit less volatility than public market bonds. They are somewhat less liquid, but that is partly because investors tend to buy and maintain these assets rather than because of small size—in fact, all six are very large markets. Less trading also means they tend to exhibit less volatility than public market bonds.
The range of spread advantage varies significantly, with U.S. dollar yield profiles generally observed to be between 25 and 400 basis points higher than those of comparable public credit markets. In European private loans, for example, BBB rated issuers can offer some 250 basis points of spread over corresponding euro corporate credits for seven- to 12-year tenors.
We hear insurance investors express concern that the higher-rates window has not remained open long enough to refresh portfolios without crystalizing losses in legacy bonds, and wariness of credit risk in advance of a likely U.S. economic slowdown. We believe both concerns may be a little overstated, but we do see a case for alternatives solutions to public credit markets at current spreads.
One solution, in our view, may be high-quality, yield-boosting private fixed income assets. We think pricing in these private assets may remain more stable than in public markets through an economic slowdown; and slower growth would afford an opportunity to rotate or move profits from core government bond exposures into investment grade spread sectors at more attractive valuations.
