Deutsche Bank to Bond Investors: Wake Up and Smell the Fundamentals

There's reason to be cautious about investment-grade corporate debt

And the Best Time for Drinking Coffee Is…

Pop quiz. Which corporate debt has performed better this year—the U.S. dollar-denominated bonds issued by Russian companies or investment-grade U.S. corporates?

If you answered Russian ones, well done. For all the talk of Russia's economic woes, it's actually the bonds issued by some of America's most creditworthy companies that have lost ground so far in 2015. In fact, as Bloomberg's Lisa Abramowicz reported on Wednesday, prices of U.S. investment-grade bonds have fallen 1.1 percent in the first two days of June alone. Why the (rather sudden) lack of love for what was once one of the hottest asset classes around?

Deutsche Bank strategists Oleg Melentyev and Daniel Sorid have some thoughts.

In short, they figure that investors may (finally) be turning against an asset class that has been booming in recent years. Deutsche Bank notes that retail money has been pouring into intermediate and long-term investment-grade mutual funds at a rate of 20 percent or more per year. The size of the overall corporate bond market has exploded from $5.4 trillion in 2009 to $7.8 trillion currently as companies rush to take advantage of ultralow borrowing costs and investors keen to buy their debt.

That dynamic has helped fuel a buyback boom and improvement in corporate earnings per share, which may otherwise have been stagnant in a lackluster economic environment.

The boom has also meant corporate balance sheets are looking even more fragile. Even stripping out oil companies, which have seen their debt-to-earnings ratio rise thanks to falling crude prices, U.S. companies are looking more levered than they used to be.

And with interest rates in the U.S. expected to move up sometime this year, it may be that investors are finally starting to consider fundamentals when they look at investment-grade corporate debt.

Here's what the Deutsche Bank strategists say:

Issuers are embracing the trend toward weaker fundamentals with both arms. Not only are debt loads rising, but EBITDA [earnings before interest, taxes, depreciation and amortization] levels are also falling, and have dropped for two consecutive quarters. Again, as Figure 2 shows, this is not merely a consequence of oil prices. A third measure of deteriorating balance sheets, interest coverage, captures the IG balance sheet deterioration best. While IG issuers have had two years of <3% IG index yields to refinance legacy debt issued in an environment of >5% overall IG yields, issuers have actually lost ground in their ability to cover interest expenses with EBITDA. Interest coverage, as shown in Figure 3, is as weak as it’s been since 2009, and lower than pre-crisis levels. Again, the energy sector is not the only culprit.

Weak global growth and a low interest rate environment play an important role in understanding how balance sheets got to where they are. Issuer debt loads, even on a net basis, have been growing at an annual rate of roughly 10 percent as companies take advantage of cheaper borrowing costs to finance acquisitions or repurchase stock to support EPS [earnings per share]. With end demand still tepid globally, company management teams can crank up leverage to boost return on equity. Investors, starved for yield, have been happy, thus far, to earn the greater spread compensation that comes along with greater issuer leverage.

As the Fed prepares the market for the end of the period of zero short-term rates, we may be approaching a reassessment of just how much leverage is appropriate given the overall market compensation.

One to watch.

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