Jeremy Sterngold, Head of Fixed Income
Looking back over the past eighteen months, the movement in corporate bond spreads has been nothing short of astounding. In early 2020, prior to the pandemic, US investment grade spread levels grinded towards their lowest level since late 2007. As the health crisis escalated and resulted in large scale lockdowns, all risk assets faced enormous pressure. Credit conditions deteriorated rapidly and liquidity dried up as investors scrambled to reduce risk but found it increasingly difficult to sell these assets. Compensation levels for corporate bonds rose to the highest point since the financial crisis of 2008/09. The key difference during this crisis was the speed and willingness of central banks to support this vital market.
In the 2008/09 crisis, funding conditions remained difficult for a prolonged period of time, resulting in large scale redundancies and long periods of elevated unemployment. An approach that policymakers wanted to avoid repeating this time around. Concerns that an inadequate response to the pandemic could lead to a great depression resulted in aggressive intervention. While the European Central Bank (ECB) and the Bank of England had already bought some corporate bonds during the 2008/09 crisis, this time the US Federal Reserve (Fed) was given powers to do the same. As liquidity became abundant and fiscal programs such as the Furlough scheme and the Paycheck Protection Programme were launched to support businesses, risk assets bounced back.
Following successful vaccination developments and roll outs, compensation for US investment grade corporate bonds continued to decline. A combination of plentiful liquidity and the highest expected nominal growth in decades should lead to strong revenue growth, resulting in stronger balance sheets. In addition, with overall borrowing costs so low, investment grade companies should find it even easier to cover their interest costs. While this backdrop may help explain the low levels of compensation demanded for corporate bonds, with spreads now below their pre-crisis levels, one has to ask if any value remains. Furthermore, if we adjust the index for credit quality and average maturity, we could argue that we have reached new all-time lows in terms of spread.
As a credit investor, you get additional yield over and above government debt for a multitude of reasons, for example: business risk, liquidity, transactional (M&A, debt issued for share buybacks) and future supply. The current economic recovery has suppressed the majority of the business risk for sectors outside of leisure and plentiful liquidity has taken that premium out. Looking ahead, the Fed has indicated that its looking to decrease the pace of its purchases and look to eventually exit its ultra-loose monetary policy stance. In addition, the ECB has said it may also the decrease the pace of its purchases. As liquidity conditions are likely to deteriorate over the medium term, corporate bonds are looking stretched. By comparison, government bond yields have risen in anticipation of tighter monetary policy over the medium term and in some parts of curve we are starting to see some opportunities for balanced portfolios.
However, there is one key difference between today’s credit environment and that seen in the 2005 to 2007 period. With prevailing interest rates significantly lower (Treasuries maturing in five years’ time hovered around 4% then versus 0.9% today), as a percentage of overall yield from holding a corporate bond relative to its Treasury equivalent, it still looks attractive on that metric. Therefore, if you are a buy to hold investor, considering selective short to medium dated corporate bonds should still see you somewhat better off than just reverting to government bonds or cash.
In conclusion, while we see valuation as stretched and acknowledge the reasons for overall spread levels to rise in the medium term, holding short dated corporate bonds still makes sense. If we see government bonds pricing in more policy tightening going forward, while credit remains relatively benign, this could give us scope to reduce our allocation to this market in favour of more government debt.
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