About a year ago one vein of concern we pushed back against was alarm over the massive amount of bonds corporate America was issuing. US investment-grade credit did hit a new record in 2020, exceeding $2 trillion of gross new supply, whereas that figure averaged approximately $1.3 trillion in the preceding five years. What gave us comfort in being healthily overweight IG credit in our strategies then was: (A) the origin of the recession—it was a reduction of economic activity by government edict rather than due to massive imbalances in corporate fundamentals; (B) the defensive nature in how corporate management was responding to the crisis—cash raised was held and not distributed to equity holders, and (C) attractive valuations. Roll the calendar forward to today and overall index spreads have not only fully recovered but have touched levels not seen since early 2007, before the financial crisis. While valuations are no longer obviously cheap, we believe the risk/reward framework is still supportive due to favorable fundamentals, technicals and valuations.
With almost 90% of the S&P having reported Q2 earnings and more than 80% of those beating expectations, on both the top and bottom line, corporate fundamentals are solid. Leverage metrics are starting to turn south due to both passive (earnings growth) and active (debt tenders) deleveraging efforts. Headwinds are emanating from supply chain disruptions and input cost increases; however, against that backdrop management has wrung savings through productivity enhancements (as witnessed by GDP fully recovering while the labor market is still shy of pre-Covid levels). The banking system, which is the lubricant of credit transmission needed for economic growth, not only survived Covid but has thrived and is in better shape than ever. We are always on the lookout for re-leveraging activity (e.g., LBOs), but the pieces are in place for corporate fundamentals to remain strong and/or improve should the reopening theme gain further momentum.
The supply/demand backdrop also remains supportive. Supply is on track to exceed the pre-Covid years but is down drastically from last year’s pace, while demand continues to be robust. Globally, the hunt for yield continues with about $16 trillion of negative-yielding debt outstanding. We’re still in the summer months and cumulative YTD fund flows into IG bond funds are already nearing full 2019 and 2020 levels. Add to that the demand from private pensions legging further into LDI as their funded statuses have improved. Also fast approaching is likely demand from multi-employer pensions; within the American Rescue Plan (the $1.9 trillion Covid relief package passed in early 2021) was a bailout of severely underfunded multi-employer plans. The Pension Benefit Guaranty Corporation (PBGC) estimates that the US Treasury will distribute approximately $94 billion to plans in need with the stipulation that these Special Financial Assistance (SFA) assets must be invested in IG bonds.
While only just fair from a historical comparison perspective we don’t see any potential catalyst on the horizon that could take overall spreads meaningfully wider. As mentioned earlier we are watching for signs of late-cycle behavior, such as LBOs (there have been a good deal of assets allocated to private equity), but the risk tone in the credit markets these days is swayed by macro issues such as whether Covid variants may derail the reopening momentum. And just like the population, firms have also built up some immunity (from a business operating model perspective), while policymakers now have an expanded emergency playbook of tools tested last year.
We believe the spread compression trade is largely behind us—but even if spreads trend sideways, credit should outperform the other major sectors of the IG bond market, namely governments and fixed-rate mortgages. Within credit we still see opportunities in banks (ratings upgrades should be coming shortly), energy (trades wide of almost all other industrial subsectors even as underlying oil prices are now higher than where they were pre-Covid) and the reopening sectors.