The other day I saw an article on Bloomberg which supported my thesis that credit (corporate bonds) is still attractive and investors should remain overweight the sector. Within the article, it stated:
Investment-grade corporate bond yields in the U.S. fell to a record low as the economy grows enough to allow borrowers to meet debt payments while failing to spark faster inflation that would boost equities.
Yields declined to 3.392 percent yesterday, below the previous record of 3.404 percent set on March 2, according to the Bank of America Merrill Lynch U.S. Corporate Master index. Company bonds globally have gained 0.38 percent this month, beating stocks for the first time since December as the MSCI All-Country World Index (MXWD) lost 2.4 percent.
Being a contrarian by nature (in the sense that when you see stories supporting your thesis too often, things are changing), I decided it was time to dig into the thesis and see if it still holds, and if we are close to an inflection point.
One thing to keep in mind as we proceed is that I am referring to the spread (risk premium) of corporate bonds, not the price or absolute yield (as the risk free rate can be hedged). The tightening of spreads (even in a rising rate environment) will lead to excess performance relative to the risk free rate.
The first step in the process is to look at spreads over time and determine where they are currently with respect to historic "norms" (All data and charts in the following section is from Barclays Capital and used with permission):
Five year spreads:
(click to enlarge)
Looking at the five year credit sector, we can see that spreads remain above their historic norms and still have some room left to tighten (mean reversion, if you will). Looking across the ratings spectrum, what stands out is that lower rated credit are highest versus their historic norms with "BB" and "B" rated credits having the highest differences and within investment grade space, "BBB" offers the most value.
While there is not a "5B" option, there is typically more value here than in "BBB" or "B" space in terms of spread relative to risk (default probability). While "BBB", "BB", and "B" are trading at their mean spreads, the 2008-2009 period significantly distorts the mean. The following is the same credit spreads from 1/04 to 12/07:
(click to enlarge)
Now the spread data (derived from the above charts):
| Rating | Current Spread | '04-'07 Avg Spread | 10yr Avg Spread |
| A | 108bps | 80bps | 140bps |
| BBB | 191bps | 104bps | 210bps |
| BB | 417bps | 211bps | 418bps |
| B | 614bps | 330bps | 659bps |
While I realize that we are not quite in the 2004-2007 time period due to events such as Europe and a slower growing China, I also realize that corporate balance sheets are in better shape than they have been in years, thus I would posit that we should look at a blend of the averages. Doing so still supports the thesis that credit is attractive in the five year tenure.
Ten Year spreads:
(click to enlarge)
Ten year spreads are similar to five year spreads as they are above the "norm" and have room to tighten further. Looking across the rating spectrum, it is evident that lower rated credit is more attractive than higher rated credit from a mean reversion standpoint, and, therefore should outperform higher rated credits. Within the lower rated credits, "BBB" in ten years is not as attractive as "BB" and "B" as it trades only 5bps higher than the mean relative to "BB" at 17bps and "B" at 8bps. Of the three, "BB" is most attractive. While "BBB", "BB", and "B" are trading at their mean spreads, the 2008-2009 period significantly distorts the mean.
The following are the same credit spreads from 1/04 to 12/07:
(click to enlarge)
| Rating | Current Spread | '04-'07 Avg Spread | 10yr Avg Spread |
| A | 124bps | 88bps | 131bps |
| BBB | 213bps | 119bps | 207bps |
| BB | 423bps | 233bps | 406bps |
| B | 644bps | 372bps | 637bps |
Again, while I realize that we are not quite in the 2004-2007 time period due to events such as Europe and a slower growing China, I also realize that corporate balance sheets are in better shape than they have been in years, thus I would posit that we should look at a blend of the averages. Doing so still supports the thesis that credit is attractive in the ten year tenure as well.
Demand:
According to a recent Wall Street Journal article:
Dealogic counted 21 deals adding up to $8.3 billion this week, enough to beat the $5.8 billion last week but well below the first-quarter average of $23.5 billion.
The average deal received 4.84 times the needed orders, up from 3.56 a week before, but new-issue concessions--the extra yield on new-issue bonds, versus outstanding issues from the same borrower--ticked up two basis points to 14 basis point, according an investment bank tracking the figures.
"The forward pipeline is building, and next week should be more active relative to the previous two weeks," the bank added.
A quick look at the size of the new issue market and the demand for new issues (as measured by oversubscription) indicates that there is still significant demand for new deals. Given the demand, I would not be surprised to see the new issue concession grind a little tighter.
So far, the thesis remains intact, but there are signs that headwinds are building, and further tightening will be more difficult - not that it won't happen, just that the "low hanging fruit" has been consumed. Let's take a look at some of the signs of headwinds:
The premium problem:
(click to enlarge)
Source: Barclays
As the above chart illustrates, a large majority of bonds trade at a premium to par, some by quite a bit. Investors will buy premium debt (which is currently paying approximately 35 basis points above lower dollar paper), but there is a cost of doing so and many investors are not willing to pay to high a premium given the asymmetric nature of the bond market. As more issues trade at a premium (and therefore a yield concession), it makes further tightening more difficult. This speed bump can be lowered with higher rates (which usually tightens spreads anyway) as dollar prices fall.
Low absolute rates:
Low absolute (all in) rates act as a deterrent for many investors. With the five year treasury at 0.81% and the ten year treasury at 1.93%, it is hard for investors to get excited about absolute yields - especially if higher rates are on their way (while recent economic data is "iffy", it does have a slightly positive tone). As well, we must remember that fixed income investors (institutionally) manage fixed income, not equities, not commodities. This means, essentially, credit markets (among other fixed income markets) have a captive audience which must continue to invest.
Bank downgrades:
Banks continue to be in the sights of the rating agencies and they have begun to review their ratings of the biggest banks (which are significant in the various credit indices). Further downgrades or multiple notch downgrades could negatively affect investor confidence as well as the ability of the larger banks to make markets and take risk positions in the credit markets.
Bottom Line: While there are headwinds facing the credit markets, I believe there is room for additional spread tightening and positive excess returns. As a result, I continue to recommend investors stay overweight credit, especially in the "BBB", "BBB/BB" and "BB" rating sectors. In future articles (hopefully soon) I plan to explore vehicles that investors can utilize to take advantage of the credit sector's expected outperformance.
Disclosure: Long LQD.
