(Bloomberg) -- US corporate bond investors will likely start 2025 with the most challenging valuation backdrop in decades, but attractive yields should keep the asset class compelling, according to analysts at Goldman Sachs Group Inc.
Investment-grade and high-yield bond spreads are expected to stay within the same range that has prevailed for most of this year, analysts led by Lotfi Karoui and Spencer Rogers wrote in a note Tuesday. That would mean excess returns — or gains over Treasuries — would be low and driven by simply holding on to the bonds, or carry, according to the note.
Average high-grade bond spreads were unchanged at 77 at Tuesday’s close, after narrowing to their lowest levels in more than 25 years earlier this month, according to data compiled by Bloomberg. Junk-bond spreads closed at 266 basis points, days after touching 253 basis points on Nov. 12, the tightest since 2007.
“Barring a selloff between now and year-end, investors will likely enter 2025 with the most severe valuation constraints in more than two decades,” wrote the analysts. “Owing to the still strong level of yield support, we expect 2025 will feature another solid year for total returns.”
Another appeal for credit is that dispersion remains elevated in the junk market, which creates an attractive opportunity in specific names, wrote the analysts. They also expect a friendlier regulatory environment for mergers and acquisitions next year to likely fuel more dispersion in the high-grade market. Negative shock to fundamental and technical backdrop would trigger a valuation reset but that’s not their base case, they added.
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“Valuation Conundrum”
The experience of the post-global financial crisis period has left some market participants skeptical that spreads will remain within their recent range, according to Goldman. In 2014, for example, high-grade only remained below 100 basis points for five months before sharply retracing to nearly 200 basis points by first-quarter of 2016. But there are many counterexamples where high-grade and junk spreads broke below 100 basis points and 350 basis points respectively for a sustained period.
“To be clear, we are sympathetic to the growing discomfort among investors over the current valuation conundrum, a key reason to keep a dose of hedges in portfolios,” they wrote.
Goldman sees mid-1990s as the period that best resembles the current situation. At the time, high-grade spreads stayed below 100 basis points for more than four years and the Fed hiked from late 1993 to early 1995 and achieved a soft-landing followed by some adjustment cuts over the next several years during a period of above-trend growth.
“If the current episode, which is 9-10 months old, ends up resembling the mid-90s, spreads could remain in their current neighborhood for many more quarters,” they wrote.
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