Corporate Bonds Have Plenty of Fans Even After ComedownBy and
Investment-grade bonds seen in a technical sweet spot
Duration risk favors corporates over benchmark sovereigns
The credit-market selloff that has dragged valuations down from stratospheric heights may not be as dire as foreshadowed by prominent money managers from Pacific Investment Management Co. to DoubleLine Capital.
The waning appetite for high-yield securities, which has sent measures of global risk back to April levels, may prove short lived, however, with shorter-duration credit offering a cushion against interest-rate increases. Growth around the world, meanwhile, is moving in lockstep, boosting corporate profits and debt-servicing firepower for issuers with strong and more-fragile balance sheets alike.
Here are a couple of reasons why bulls can once-more take charge of U.S. and euro credit markets.
1. Junk Bonds Have a Cushion Against Rising Rates
One measure of risk -- interest-rate moves -- suggests holding Treasuries is scarier than credit as the Federal Reserve and European Central Banks embark on tighter policy.
“Sure, you don’t have the spread risk you have in credit, but you have duration risk and a lot of investors underestimate that,” Robeco money manager Jeroen Blokland told Bloomberg News, referring to the sensitivity of bond prices to changes in borrowing costs. “That means that rising interest rates have a much bigger impact on the price of U.S. Treasuries.”
Robeco trimmed its exposure to high-yield credit in its multi-asset funds two weeks ago cushioning against the selloff, but remains overweight the asset class. In a blog post ‘Have bond investors now truly gone mad?’ Blokland suggests low high-yield European spreads can be justified by the economic upturn in the trading bloc, and low government bond yields. Junk bond yields in the region converged with U.S. Treasuries earlier this month, prompting DoubleLine chief executive Jeffrey Gundlach to lament investors were ‘wack-o.’
2. U.S. Corporate Debt Outperforms
Corporates have historically fared well in a benign climate of rising interest rates. Bonds, especially from high-rated companies, have had a negative correlation with U.S. Treasuries, according to Goldman Sachs Group Inc. In other words, borrowing costs have risen in tandem with expanding economic output at the same time as credit bulls have taken control, emboldened by an upturn in risk-taking and corporate earnings.
High-yield bonds have also outperformed when Treasury yields have advanced more than 100 basis points, according to research from asset management firm Lord Abbett & Co., as investors favor lower-duration assets or place bullish bets on the economic cycle.
3. Technical Sweet Spot for Investment-Grade Bonds
Hans Mikkelsen, Bank of America Corp. credit strategist, is in the bullish camp, suggesting risk premiums for obligations issued by companies with strong balance sheets could fall over the next two quarters.
Gross leverage among high-grade U.S. corporates is set to decline from record levels, he says, amid weaker bond supply and likely oncoming tax-reform policies that should boost domestic cash holdings. Bank of America calculates that net leverage, which includes cash on balance sheets, among U.S. investment-grade issuers, excluding financial, commodity and utility firms, is 1.72 times earnings before interest depreciation and amortization, versus a peak of 2.15.
Voracious appetite for high-rated bonds in euros and dollars this year "can be justified by the low levels of corporate defaults, and the fact that leverage and interest cover for investment-grade companies have only seen modest increases in recent quarters," adds Jim Leaviss, head of retail fixed interest at Prudential Plc’s M&G Investments.
4. Flows, Flow, Flows
Despite bearish rhetoric from money managers over the past two weeks, there’s been a notable absence of large multi-asset managers announcing strategic shifts out of bonds in favor of stocks. "We see no evidence for the rotation trade -- sell credit (a capital preservation, low-yield strategy) to buy equities (capital appreciation, higher returns strategy) right now," says Suki Mann, founder of bond-market analysis firm CreditMarketDaily.com.
Mann projects the euro primary market will play catch-up after the summer-supply lull, which will likely foster confidence about investor appetite for credit as deals price aggressively, in tandem with the uptick in economic growth -- spurring tighter spreads once again.