The overwhelming consensus going into 2014 was that equities would benefit from the recovering growth story and that fixed income would suffer. Neither has played out. Offering less yield than their racier high yield cousins and yet sensitive to the price moves in government bonds, it was easy to see why many thought IG corporate bonds would be one of the laggards of the market.
While this has confounded many investors, looking at the drivers of the IG corporate bond market can help shape an informed outlook for the future.
First, demand and supply matter. A lot. This may seem an obvious statement but nowhere is this more true than in Europe where yield starved investors look to the IG corporate bond market as the next logical step when the returns offered on their savings deposits continue to dwindle. The cut in policy rates by the ECB will only be a further catalyst for this trend. Strong demand isn’t just a feature for Europe though. In the US not only do retail funds continue to see healthy inflows but importantly institutional investors are a “natural” buyer of IG corporate bonds. The drivers here are pension plans that want to lock in a better funded status by purchasing long maturity IG corporate bonds and also corporations with large cash balances moving out from commercial paper into shorter maturity corporate bonds.
Supply is also constrained. This is particularly true of banks in Europe which are still deleveraging, meaning they are lending less than they used to so in turn need to issue less debt themselves. As a result, investors are often left chasing fewer and fewer bonds. Another point to bear in mind here is that as corporate bonds mature and coupons are paid this money will often be re-invested back into the IG market which adds a further layer of support.
Second, fundamentals are strong. In the US, corporate earnings are at healthy levels with full year estimates for S&P 500 companies currently on course for 7.5%. With economic growth though running a lot lower than that there is indeed the risk that corporations will favour shareholders over bond holders by returning their cash as dividends.
Even worse for bond holders, companies may choose to borrow more debt to fund an M&A shopping spree. While M&A activity has certainly reached levels not seen since 2007 the key difference is that a much greater proportion of the funding this time around is with the acquiring companies’ own stock. Indeed, both in the US and Europe, M&A has often been greeted with lower spreads (the amount of yield for a corporate bond over a comparable government security) for the companies involved, particularly the target. Europe itself is still in the sweet spot for bond holders with active deleveraging remaining a priority for many company executives. In particular European banks continue to strengthen their balance sheets by running down non-core operations and issuing both stock and subordinated securities. All this serves to offer more protection to holders of their highest quality bonds which form part of the IG corporate investment set.
However, the market is indeed expensive. Against the backdrop of a very supportive demand and supply picture and steadily improving corporate health, spreads have tightened. More so, total returns have been propelled forward by an unexpected government bond rally this year. Spreads of Global IG corporate bonds are still optically wide to the tightest levels seen pre-financial crises, when you adjust for slightly lower average credit quality assigned by the ratings agencies this time around, there isn’t a lot of “compression” of spreads left. Having said that, at this stage of the economic and credit cycle this isn’t all that unusual. The question investors need to ask themselves at this point is whether we can expect smooth sailing or stormy seas ahead?
Following on from the argument that corporate fundamentals are strong and IG bonds are still appealing to a wide range of investors, another important point to highlight is that in the last year when pockets of volatility have surfaced in markets, the IG bond market has remained remarkably resilient. Wobbles in the stock market and riskier parts of the debt world are now met with indifference from the fortress of the IG corporate bond market, in contrast to earlier, more uncertain stages of the global economic recovery when they would have suffered similarly.
There is still plenty of opportunity in IG corporate bond markets. While overall market valuations are not what they used to be, security selection based on careful and detailed credit analysis is a means to earn return in portfolios. In addition, the IG corporate bond market as a whole, while not as attractive as it once was, is still a long way from its final swan song.
