In our baseline scenario—in which inflation falls Corporate bonds: Cheaper valuations, throughout 2023 but remains above the Fed’s but downside risks remain 2% target and the federal funds rate rises to Despite a record pace of Fed tightening and 4.5% and stays there for the next 12 months a historic rise in Treasury yields in 2022, credit before gradually falling to 2.5%—we expect the spreads have remained remarkably resilient. 10-year yield to peak around its recent highs Our fair-value framework, shown in Figures II-7a (4%–4.3%). In a more pessimistic scenario— and II-7b, uses the same four variables to model shown by the top of the gray band in Figure investment-grade and high-yield spreads but II-6—the Fed’s fight against inflation forces it finds that these variables differ in their to raise rates as high as 5.7%. In this scenario, importance. For instance, both investment-grade the 10-year yield could peak as high as 5.5%. and high-yield spreads are most sensitive to If the fight against inflation requires less action economic conditions, but the slope of the yield from the Fed, the 10-year yield has likely already curve matters more for investment-grade than peaked, and we would expect lower 10-year yields for high-yield. Conversely, high-yield is more as policy rates normalize more quickly. No matter sensitive to corporate debt fundamentals given the scenario, our view that the Fed will ultimately its riskier credit profile. be successful in bringing down inflation means that it will be difficult for long-term yields to Over the last 12 months, worsening economic remain above their historical average from the conditions from inflation and the Fed’s fight to past 35 years. contain it have been the main factors pushing credit spreads higher. Tighter policy is also raising Expected long-term inflation rates implied by the risk of a recession, which leads the yield curve Treasury Inflation-Protected Securities (TIPS) to invert and could put downward pressure on also support this view. Breakeven inflation rates profits and debt sustainability metrics. Strong peaked in the first half of 2022, as energy prices balance sheets, however, have prevented spreads reached record highs, at 2.98% annually over the (especially high-yield ones) from widening further. next decade. These expectations have since Although both investment-grade and high-yield moderated to 2.15% as of September 30, 2022. bond spreads are within our fair-value range, it is This is below our median VCMM 10-year annualized reasonable to expect that they could widen more inflation forecast of 2.5% (see Figure II-5a), which given our outlook for weaker economic conditions, leads us to view longer-term inflation protection high short-term interest rates to fight inflation, as cheaper than last year but within our fair-value and slower corporate profit growth. range (see Figure II-5b). Higher TIPS returns are a result of inflation exceeding market expectations. To that end, only upside inflation surprises will create excess return opportunities. Regardless of their attractiveness from a valuation perspective at any point in time, TIPS offer some benefit to long-term investors who are sensitive to inflation risk. 43