High grade credit: you get what you pay for
Taking a face value look at current investment grade (IG) corporate bond spread levels, it would be hasty to conclude that the asset class is overvalued. Levels are not too far out of line relative to history, but the extent of the move since the crisis and convergence of spreads across different parts of the market, combined with indicators that we are late-cycle, have given rise to this view.
The significant move in spreads reflects the distorting effect of central banks’ extraordinary monetary stimulus measures over recent years, which have given investors the security to go after yield and buy the market indiscriminately. With the gradual removal of ultra-accommodative policy now underway, some greater divergence and differentiation within the corporate bond market would likely result, giving way to greater stock selection opportunities.
Bottom-up analysis of the market also reveals a number of broad positive fundamental characteristics and shifts in IG corporate bonds. Corporate default rates are low, corporate balance sheets are healthy and over recent years where defaults have occurred, the recovery rate for bondholders has been above the historical average.
- The secular trend of spread compression over recent years will eventually reverse, allowing for idiosyncratic risk to be priced in once again.
- Companies are far more fiscally conservative than the pre-crisis era, with strong balance sheets and cash flow generation making them well-positioned for macroeconomic slowdown.
- Low corporate default rates, which simultaneously facilitate lower default losses, help explain tighter spreads.
Don’t forget heterogeneity
Prolonged central bank purchase programmes and liquidity pumping have seen any macro headwinds met by waves of bids into weakness. This has resulted in spread convergence within the credit universe between sectors, ratings, and individual issuers. Blanket spread compression has seen a narrowing of the premium provided by higher carry bonds versus lower ones. The average spread between BBB-rated issuers and A-rated issues has fallen by 40bps over the past five years in both euro and US dollar IG credits and the standard deviation in spreads between issuers has decreased significantly.
The unwinding of ultra-accommodative monetary policies should precipitate a reversal of spread convergence and a refocusing on fundamentals. This should pave the way for active asset selection to become favourable over pure beta approaches once more.
European companies have shown an almost surprising degree of prudence over the past few years, borne out by a number of metrics. At an aggregate level, the ratio of debt to EBITDA has fallen significantly since 2016, while the ratio of capex to sales is in-line with the long-term average. Perhaps most strikingly, interest coverage – the ratio of EBITDA to interest costs – is at a historic high.
Balance sheet metrics are not as strong in the US where there has been a greater propensity for shareholder-friendly measures such as share buybacks. Nevertheless, balance sheets are healthy. While the level of interest coverage and cash held on US balance sheets is lower than in Europe, companies are growing free cash flow strongly and achieving improved pricing power.
The US energy sector is a handy case study in the need to disaggregate when looking at the asset class. Energy was largely accountable for an overall rise in default rates between 2014 and 2016 due to the shale boom. The sector has since reined in debt levels and defaults have declined.
Above-average recovery rates
Across nearly all bond seniorities, debt recovery has in the recent past been materially higher than the long-term average. This is explained by the fact that a large proportion of defaults which have occurred have been in the energy sector, where companies can resort to liquidation of physical assets. There is also a correlation between low default rates and high recovery rates.
Over the past decade, sustained economic expansion and abundant liquidity has translated into strong corporate earnings growth, which combined with greater fiscal responsibility has resulted in much healthier balance sheets. The debate surrounding how spreads will react as monetary policy shifts and global growth moderates will continue. For those that wish to access high grade credit, they can take assurance that fundamentals remain robust.
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