The Historic Rally In Corporate Bonds

Summary

• The rally in corporate bond spreads over the past 50 trading days echoes the tremendous spread rally seen in the early days of the economic recovery in 2009.
• Investors in investment grade corporate bonds have done quite well even as government bond investors have fared poorly amidst higher interest rates.
• With investment grade corporate bond yields approaching historic lows, the risk-return tradeoff in corporate credit has weakened.
• Very attractive financing rates for investment grade companies supports broader equity markets, reducing the cost of capital for companies and reducing the risk of financial distress.

Most investors are aware of the historic nature of the equity market rally. Since the lows on March 23rd, the S&P 500 (SPY) has rallied nearly 40%. Gains this large over this short of a time period have not been seen since the Great Depression. An amazing rally is also taking place in investment grade corporate bonds, and the scope and scale of that rally may have a positive feedback loop on the economic recovery and broader asset markets.

The graph below shows a 20-year history of investment grade corporate bond spreads. These spreads refer to the average spread premium above similarly matched Treasuries for investment grade rated companies. The spread widening in the first quarter of 2020 eclipsed every other previous stress episode - the TMT blowup in early 2000s, 2001 recession, 9/11, the debt ceiling debacle of 2011 and U.S. downgrade, rolling sovereign debt crises, the 2015-16 commodity crisis, and the late 2018 swoon - trailing only the Global Financial Crisis in 2008-2009.

The next graph shows spread changes over 50 trading day intervals. The spread widening that peaked on March 23rd, 2020, saw spreads widen from 97bp over Treasuries to 373bp over Treasuries over 50 trading sessions. That was the sharpest period of spread widening since the period ending November 21, 2008 when spreads had widened 292bp to 604bp over a similar time horizon. The notable difference, of course, is that spreads were very tight prior to the recent blowup, reflecting the magnitude and exogenous nature of the economic shock.

Spreads have reversed as quickly as they widened. Over the last 50 trading sessions from the recent wides, spreads are 217bp tighter - from 373 to 156. This is the sharpest spread rally since the periods ending in June 2009. At that time, three months after stocks had bottomed during the Global Financial Crisis, spreads were still in the low 300s. Spreads in 2009 did not reach current levels until March of the following year.

What is different in this episode? The Federal Reserve had a blueprint, hard earned during the Global Financial Crisis, to help them manage this unique crisis event. They even pledged to buy corporate bonds for the first time, and got little push back on whether that was outside their mandate. A "buyer of last resort" emboldened credit markets to take more risk. It has worked even though the Fed has yet to buy an individual bond (it has bought credit ETFs).

With all-in interest rates still historically low, this spread tightening has pushed investment grade corporate bond yields within 15bp of their all-time low yield levels reached earlier this year. Despite coincident depression-like economic data, credit markets are as receptive to borrowers as they have ever been, offering near record low rates. Companies have responded with record borrowing. If you have an investment grade balance sheet, the market has provided you a liquidity bridge. Even companies in directly impacted sectors - airlines, aircraft leasing, hotels, commodity producers - have had access to credit. For equity investors who view current equity values as a present value of probabilistic future outcomes, the open and cheap access to capital has cut off the tail risk of bankruptcy outcomes. For equity investors who view current equity values as a future cash flow stream discounted back to the present, that discount rate is getting very low, driven by low interest rates and sharply lower credit spreads.

On April 7th, about two weeks into the current spread rally, I published "A History of IG Credit Spreads Suggests Opportunity", I highlighted that then prevailing credit spreads were pricing in multiples of the worst default rates that had ever been seen. The article indicated that for fixed income-focused investors taking broad exposure to investment grade corporate bonds will generate solidly positive excess returns over the intermediate to long term.

The graph below shows the performance of the iShares iBoxx $ Investment Grade Corporate Bond ETF (NYSEARCA:NYSEARCA:LQD) versus the iShares 20+ Year Treasury Bond ETF (TLT) since the wides of credit spreads. If you owned long duration credit, you have done quite well (+15%). If you owned simply long duration government bonds, you have lost money.

Source: Bloomberg

Like equity markets, investment grade bond spreads have had a tremendous rally. Credit spreads exhibit momentum, and we are likely to see continued short-term spread tightening, albeit at a moderating pace from the rapid recent rally. Yields have pushed down towards historic lows, a supportive element for broader capital markets. With investment grade corporate bond yields approaching lows amidst outstanding economic risk, the risk-return relationship has grown more poor.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties, and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Analyst’s Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.