Plenty of people look at equities and question whether market sentiment has run well ahead of the macroeconomic reality. Then there is corporate credit, a crucial area of fixed income that has been backstopped by several central banks and for good reason.
No one wants the current pandemic recession to become a financial crisis via a surge in credit market volatility. The ultimate backstop has not just reversed the pandemic-inspired rout of credit — with the Moody’s Baa credit index now yielding less than its February level — it also triggered an avalanche of corporate debt sales. This has bought companies breathing room and allowed them to amass reserves that hopefully tide them over until the economy recovers.
Bond fund managers have lapped up the record pace of new debt sales since March. By the end of June US investment grade debt sales totalled $1,225bn for the year to date versus $597.4bn over the same period in 2019, according to Sifma. In contrast, sales of high-yield debt have lagged, reflecting the greater risk of a default wave rippling through this riskier slice of the credit market. Sifma shows high-yield sales running at $200bn so far this year to the end of June, versus a figure of $137.4bn for the same period in 2019.
So far this month new issuance activity has dwindled as shown here from Bank of America:
Betting on investment grade has clearly been a big and rewarding trade as highlighted by this link to Bloomberg Barclays credit indices. Cash has poured into bond funds and is still running at a near record pace of inflows. That needs to find a home and for asset managers, nothing looks so attractive as an asset class taking up space on the balance sheet of the Federal Reserve and other central banks. The ensuing strong performance of credit has duly compelled managers to buy into the asset class and not lag their bond benchmarks.
Now comes the hard part, or namely, what next? The bullish case for credit from here rests on a default cycle that shows a lot less teeth — although that leaves a bigger legacy of zombie companies — setting the stage for high yield outperforming. A critical ingredient for this scenario is a stronger than anticipated global and US recovery from Covid-19 which is very much a point of conjecture at the moment.
Within investment grade, an improving macro picture suggests squeezing more out of the triple B-rated segment given that higher quality paper — double B and A-rated debt — have outperformed up to now. But the impressive recovery in credit leaves some sweating.
Analysts at Unigestion note risk premiums for both investment grade and high yield on both sides of the Atlantic look rich and suggest modest returns from here:
“Current spread levels in investment grade (sub 70 basis points in both US and Europe credit default swap indices) and high yield (450bp in the US and 340bp in Europe) have historically returned 0.2 per cent and 0.7 per cent in the three months that followed. This measure rises to 0.4 per cent and 3 per cent over a 12-month horizon.”
One credit market development in recent years has been the growing role of tourist money, whereby investors with broad mandates hunt for returns across a wide range of asset classes. This aspect was well-established before the pandemic erupted and was one catalyst for the dramatic surge in credit risk premiums during March. It also explains the substantial rescue efforts from the US Fed. Clearly, this is a central bank that appreciates an acute point of vulnerability within the financial system and why it is now buying specific corporate bonds.
Contain credit stress and you appease the equity market is the current policy approach. Hence the Fed’s announcement today that its little used credit lending programmes will be extended after September until the end of the year.
This leaves investors gauging whether the economy and companies muddle through the pandemic versus alternative outcomes that up the ante in terms of market turmoil.
A nasty downgrade and default cycle, distinguished by mediocre recovery rates, will test investors and bond funds. A sharper rebound for the economy along with a dash of inflationary pressure will also prompt quite an exit trade from credit, led by the tourist money crowd.
In both scenarios, central banks will have their work cut out to stem credit angst, particularly given how companies have sought to extend the average maturity of their debt in recent months.
Over at Bank of America, its analysts highlight how duration in US investment grade credit extends “to a record 8.38 years, which means other types of investors that are more sensitive to mark-to-market risk have more yield-risk than at any time in the past”.
This means that a change in yields triggers a bigger response in debt prices. That works great in price terms when yields are falling and explains why some credit bulls anticipate there remains scope for more capital gains in the near term. But once yields start rising, prices fall a lot harder for bonds with a greater duration. That’s where the recent rush into credit — and with companies selling longer-dated debt — may have sown a bitter harvest.
“Low reward, high risk” says BofA and that’s easy to appreciate at this stage for much of the credit market.
Quick Hits — What’s on the markets radar?
One way of looking at the US companies set to testify before the House of Representatives antitrust subcommittee on Wednesday is that collectively Amazon, Apple, Facebook and Google combine for a 16 per cent weighting of the S&P 500 index. That’s a bigger slice than all major S&P 500 sectors, apart from technology (at 26 per cent).
Tomorrow’s hearing is a reminder for investors that regulatory risk stalks big tech and why a sweep in November by Democrats might shake the foundations of the US market. But in the Washington swamp, don’t forget lobbying is a company’s best friend. Just ask big banks about their post-financial crisis efforts.
DataTrek highlights another list of impressive numbers that suggest Amazon and Facebook are feeling a little more heat than Apple and Google of late:
“Amazon spent a quarterly record on lobbying last quarter ($4.66m in Q2 2020, up from Q1’s $4.51m), while Facebook spent even more than AMZN after hitting a quarterly record in Q1 ($4.83m in Q2 after a record $5.26m in Q1).”
The takeaway for investors says DataTrek:
“Lobby spending is a productive way to assess single stock regulatory risk since it reflects how much pressure the companies themselves feel.”
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