Market Views: Fixed Income
Are there still opportunities in US corporate bonds?
The early months of 2020 have truly been a rollercoaster for investors, with one of the most dramatic global sell-offs in living memory followed by a strong rebound. March saw corporate bonds and other assets go from some of the most expensive levels in over a decade, to some of the cheapest in a matter of weeks.
Thanks to the remarkable support unleashed by policymakers, markets have reversed sharply, recouping a significant chunk of the losses. While this retracement has been strong, there are still attractive opportunities in US investment grade and high yield corporate bond markets.
Investment grade yields and spreads at historic highs
The charts below show just how severely dislocated investment grade (higher quality, less risky corporate bonds) market became in March. The chart shows the absolute yield for the US dollar, euro and sterling corporate bond markets, the three major components of the global bond market. Within a period of two to three weeks in early-to-mid March, yields across all three markets rose sharply.
While some of this rise has been reversed in recent weeks, current yields are still very attractive compared to history, and to the government bond market, and will appeal to investors looking for income and capital appreciation.
Yields and spreads are compelling at these levels
While corporate bonds spreads (the additional yield demanded by investors to compensate them for the additional risk they assume compared to a government bond of a similar maturity) certainly widened more during the global financial crisis of 2008-2009, the pace of repricing this time was unprecedented.
In chart above, we can see that at the end of March, an investor could earn over 370 basis points (bps) in the US dollar investment grade market compared to investing in a similar maturity government bond. At the start of the year, the spread was around 95 bps. Such an astonishingly fast rise in spreads has seldom been seen before.
While spreads have come down since those highs following the announcement of extraordinary monetary policy measures the world over, all three major markets are clearly still pricing in a meaningful recession, at least over the near term. As such, we think the potential return, versus the potential for further deterioration in market levels, looks decidedly appealing.
New issuance reached record levels
At the height of the sell-off in March, short-term investment grade yields rose considerably as many investors looked to sell the most liquid bonds in order to shore up their cash positions. As a result, borrowing costs in short-term money markets became prohibitively high and companies were forced to issue debt to ensure they had sufficient liquidity to meet short-term obligations.
This led to a massive amount of new issuance during March and April and was further fuelled by the Federal Reserve’s announcement in late March, and again in early April, regarding the formation of a corporate bond buying programme, covering both the primary and secondary markets.
New bonds came to the market at the most attractive levels witnessed in a decade and the appetite was healthy. More than 60% of issuance came from issuers rated single A or better, providing a plentiful supply of high quality bonds at reduced prices.
While issuance remains heavy, demand reversed course in April as inflows into mutual and exchange-traded funds in the US dollar market more than offset the pronounced outflows seen in March.
Companies have many options to protect credit ratings
The likelihood of ratings downgrades is a clear concern given economic conditions, particularly the risk of so called “fallen angels” (an investment grade bond that is downgraded to high yield). In our view, a lot of investment grade companies have many levers they can pull to protect their credit ratings, at least over the shorter term.
While net debt levels for companies have been elevated for some time, over the past couple of years, they have been stable. Additionally, over the last five years, investment grade companies have spent cash on discretionary items such as capital expenditures, share buybacks, dividend payments and acquisitions. Given the current environment and the obvious need to maximise cash flow from operations, corporations have already begun to announces some changes in how cash will be spent. They can choose to curtail, freeze, reduce or eliminate any of these discretionary expenditure items affording them a great deal of flexibility during this volatile period.
High yield offers compelling value
High yield (considered riskier, and rated below investment grade) corporate bond markets have also seen extraordinary moves. Like in investment grade, we have seen a substantial retracement, but even with that, valuations remain more compelling than they have been in years.
We do expect high yield to remain vulnerable to periods of volatility going forward though. There are so many complexities around lifting lockdowns and re-opening economies that periods of uncertainty seem almost inevitable, but these are likely to present further interesting opportunities and attractive entry points into the market.
Elevated issuance but strong demand
After the effective closure of the high yield market in March, conditions have started to normalise following the Fed’s intervention. Specifically, the announcement in early April that recent fallen angels and high yield ETFs would be eligible for the corporate bond buying programme was particularly supportive. This naturally led to a shift in sentiment as investors know there is a willing and able buyer of risk with deep pockets. Similarly to the investment grade market, demand for high yield recovered substantially in April following the outflows seen in March.
One thing that has been notable over the last couple of months is how the use of proceeds for new issues has shifted dramatically as companies rushed to strengthen their cash positions. As a result, issuance for general corporate purchases surged during April and comprised 72% of all issuance, while it accounted for only 12% of issuance in the first quarter. Re-financings had been the dominant use of proceeds prior to this period as the low absolute level of rates encouraged companies to extend their debt.
Default cycle just getting started
The policy response to the economic consequences of Covid-19 may have addressed liquidity and systemic concerns around the functioning of markets, but it can’t address solvency issues. High yield companies are more likely than other parts of the market to be impacted by bankruptcies so idiosyncratic risk will be on the rise.
The default cycle has already begun. April saw the number of companies filing for bankruptcy or missing a coupon payment reach the highest level since April 2009. Rating agency Moody’s is currently forecasting an 11% default rate by year-end, compared to a historical average of around 4%.
While defaults will rise in aggregate, they’re likely to be more concentrated in stressed sectors. In energy and retail for instance, the distress ratio (percentage of companies trading at more than 1,000bps over Treasuries) was notable at the end of March and despite retracing in April, remains elevated.
Security selection key
The market levels we currently see in corporate bonds have historically preceded a period of attractive returns. But as we have shown, risks and uncertainty are higher. Near-term, companies and investors will have to contend with a recession, which will mean defaults and downgrades in credit. It is also likely that this crisis will ultimately effect longer-term, deeper changes in the economy and society. As such, while it is fair to say that investing in corporate bonds looks an appealing prospect right now, it is important for investors to think carefully about which companies they want to invest in.
We think we have now passed the first phase of this crisis, which was marked by indiscriminate panic-selling, and moved onto phase two, where we expect to see more dispersion between sectors and issuers.