What Will Satisfy the Market's Thirst for High-Grade U.S. Bonds?By
Corporate issues hit $700 billion in 2017 amid tight spreads
Investors keep their eyes on Fed unwinding, corporate leverage
The demand for U.S. investment-grade bonds shows little sign of abating anytime soon, even with the specter of hawkish central bank policies looming.
Companies sold more than $700 billion in bonds in the first half of 2017 and spreads are at at their tightest since 2014. On July 17, the Markit CDX North America Investment Grade Index, a gauge of investor adversity to risk, hit its lowest level since September 2014.
Demand is expected to remain strong for the remainder of the year, even though supply is projected to decelerate somewhat due to a thinner mergers-and-acquisitions pipeline. Full-year issuance may fall by as much as 7 percent from 2016 levels after five record-breaking years, according to a July 3 Bank of America Merrill Lynch research report. Last year’s supply totaled about $1.61 trillion, according to data compiled by Bloomberg.
As issuance threatens to slow, investment-grade corporate bond funds this year have seen some of the biggest week-over-week positive inflows in two years.
So will the feeding frenzy ever stop? While bond bulls may not be losing any sleep over a potential reversal of fortune, there are a few concerns in the back of investors’ minds.
“There always comes a time when something happens causing the market to rethink itself, and it’s usually too late,” said Joel Levington, director of credit research at Bloomberg Intelligence. Potential catalysts include disappointing earnings -- not a problem through the first half of this year -- “or a potential extracurricular shock, like a Trump tweet or some kind of other event,” he said.
The potential unwinding of the Federal Reserve’s $4.5 trillion balance sheet could be one such disruption. Where a mere rate hike would mainly affect the front end, the dismantling of the post-crisis stimulus may have a more significant impact on rates across the yield curve, according to Zachary Chavis, a portfolio manager at Sage Advisory Services Ltd., which has $12 billion of assets under management. Still, he’s not worried for now.
“In the short run, I’m having a hard time seeing any scenario where people begin dumping paper,” he said.
Flooding the market with high-quality debt such as Treasuries may put pressure on corporate AA spreads, said Jon Curran, a fund manager at Standard Life Investments. Spreads on those bonds, along with AAAs, are currently trading as narrowly as they have in three months.
Fed balance-sheet normalization and European Central Bank tapering are “emblematic of the uncertainty that global investors feel by the potential impact that a future reduction in central bank-induced liquidity could have on assets globally,” a team of JPMorgan Chase analysts led by Rishad Ahluwalia wrote in a July 14 research note.
Changes to monetary policy abroad also have the potential to cut demand for U.S. paper, as yields in other markets become more attractive. Taiwanese life insurance companies, for example, have been particularly big buyers of U.S. dollar debt, Curran said. A move -- or hint of a move -- by the ECB or Bank of Japan toward slowing quantitative easing to normalize rates may deter foreign buyers from continuing to buy U.S. paper.
ECB tapering is just one event that would stir calm seas. The September Fed meeting, a change to the Trump administration’s tax-reform timeline or even the outcome of China’s 19th Party Congress this year might also add volatility and have a secondary effect on credit markets, investors said.
Increasing leverage and U.S. corporations’ balance sheets are other long-term areas of concern, despite current bond stability, which seems to have some staying power, according to Curran.
“You can’t be complacent, and you really have to be doing credit work at this time,” he said.
Leverage is plateauing, helped by an energy sector that has vastly improved over the last year, the investors said. Credit metrics are fairly stable, for the most part, Curran said, although he’s mindful of being in the later innings of the credit cycle and adamant about security selection and identifying proper risk premiums.
“Corporate debt continues to rise, and we’re concerned that much of that debt has gone to shareholder-friendly activities like dividends and stock buybacks rather than funding growth through capital expenditures,” Charles Schwab’s Collin Martin wrote in a July 6 bond outlook.
Still, there doesn’t seem to be any industry -- with the possible exception of retail -- too stretched to cover debt service, said Jim Vogel, an interest-rate strategist at FTN Financial.
“So, where are the excesses that will cause overheating and lead to a cooling-off period? The market may have a hard time finding that this time around,” he said. “We’re watching and looking rather than forecasting and creating new strategy.”
— With assistance by Robert Elson, Lisa Loray, Lara Wieczezynski, and Molly Smith