4 February 2021
Credit where it’s due
Investment grade credit valuations have come a long way over the past 10 months. At the headline level, we are cautious, but we still see pockets of value.
As the vaccine rollout gets underway and companies look ahead to some kind of recovery in the coming months, investment grade (IG) corporate health broadly looks reasonable. With almost half of US companies having reported for Q4, results are better than feared. Revenue estimates have turned positive, suggesting growth of 0.8% in Q4 compared to original estimates of a -1.0% decline. Earnings are now estimated to decline by only 1%, vs. the 9.8% originally anticipated, reflecting better than expected margins. The biggest drivers of this improvement have been financials, materials and technology, while energy, transportation and consumer services continue to struggle. Despite these areas of weakness, downgrade activity within IG continues to slow, suggesting that ratings agencies are giving companies some time to address their balance sheets. A key factor to monitor is leverage: while we think we have already seen the peak, and high levels of issuance mean that corporate balance sheets have been shored up with excess cash, the relationship between gross and net leverage is key. Should net leverage increase at a greater rate than gross, this could be a sign that corporations are willing to take on more risk, perhaps through shareholder-friendly activities such as M&A.
With spreads at 97 basis points (bps), it is hard to get excited about IG credit at an index level – although we do think spreads should be stable from here, as long as central banks remain supportive and the vaccine rollout continues to progress. However, select parts of the global market are still appealing: hybrids, for example, provide a spread of 355 bps, which is 52 bps higher than this time last year. And on a relative value basis, US IG could still be reasonably attractive to European investors, offering a hedged all-in yield of 1.95%. (Data as at 3 February.)
Spreads are tight at the index level, but some parts of the market are still relatively attractive
Supply in the US has been relatively high so far this year, with more expected to come: the market expects telecoms issuers, in particular, to issue in late February/early March to fund forthcoming 5G bandwidth rollouts. This could weigh on spreads, but the demand appears to be there to meet the challenge. Flows in the US have been strong, with EPFR flows into high grade funds averaging USD 8 billion per week this year – perhaps indicating a structural shift from money markets into higher-yielding alternatives. US credit is also supported by demand from overseas investors, given the attractiveness of hedged yields. In Europe, issuance (at EUR 42 billion year to date vs. EUR 53 billion last year) is not such a concern, but the demand picture is also a little anaemic. Although the European Central Bank continues to buy eligible corporate bonds (over EUR 8 billion of gross purchases in January), EPFR flows have been muted, averaging EUR 450 million per week so far in 2021. (Data as at 3 February.)
What does this mean for fixed income investors?
So long as the vaccine rollout is not derailed, and barring a hawkish shock from central banks, we expect credit spreads to be well supported. However, the value on offer at the index level is questionable, and the long duration of IG credit means there is potential for significant underperformance if rates back up. We still favour parts of the market such as subordinated bank capital, given higher spreads, and we think near-term bouts of volatility – as we saw in late January – could present buying opportunities.
About the Bond Bulletin
Each week J.P. Morgan Asset Management's Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.
Our common research language based on Fundamental, Quantitative Valuation and Technical analysis provides a framework for comparing research across fixed income sectors and allows for the global integration of investment ideas.
Fundamental factors include macroeconomic data (such as growth and inflation) as well as corporate health figures (such as default rates, earnings and leverage metrics)
Quantitative valuations is a measure of the extent to which a sector or security is rich or cheap (on both an absolute basis as well as versus history and relative to other sectors)
Technical factors are primarily supply and demand dynamics (issuance and flows), as well as investor positioning and momentum