10 June 2021
With investment grade credit spreads near all-time lows, we explore why demand for the sector remains strong.
Fundamentals remain supportive for the investment grade (IG) corporate credit market. Median leverage metrics have continued to move lower as strong earnings growth has outpaced debt growth. In addition, earnings per share (EPS) growth expectations have moved higher—2Q21 S&P 500 EPS growth expectations are now sitting at 59.5% with revenue growth at 18.4% (data as of 4 June 2021). Market composition has also changed, with fallen angels having already dropped out of the market. Today, we are seeing more ratings upgrades than downgrades. Furthermore, with cash balances at high levels, companies can focus on generating liquidity to tackle any unforeseen economic weakness. Although some of the Covid-challenged sectors have yet to reach peak leverage, the patience of ratings agencies has allowed companies the time and flexibility to focus on deleveraging and repairing their balance sheets. However, with rates still low, we could see an uptick in intentional re-leveraging within IG corporate credit, which could act as a headwind to fundamentals.
The valuation story is less supportive for IG corporate credit. Currently, spreads are near all-time lows, with US IG credit at 85 basis points (bps) (2bps above five-year tights) and European IG credit at 84bps (11bps above five-year tights). In addition to tight valuations, investors need to be conscious of IG credit’s sensitivity to increases in interest rates. Moves higher in the rates curve have detracted from year-to-date total returns from this higher duration asset class, with global IG duration at ~7.3 years. Given our expectation for higher yields — driven by the reopening narrative, vaccine distribution and the direction of monetary and fiscal policy — a move higher in yields could offset any potential gains from further spread compression from already tight levels. Data as of 9 June 2021.
Alongside fundamentals, IG corporate credit is supported by an attractive technical backdrop. The sector continues to see strong global demand from both overseas buyers and retail investors, especially in the US dollar space — US IG credit has seen average weekly retail inflows of USD 4 billion this year (source: EPFR). We also see signs of increased demand from institutional buyers, such as pension funds. In Europe, retail demand has slowed due to more suppressed yields. However, central bank purchasing programmes continue to provide a key backstop to markets. Global supply has remained consistently heavy, and we expect it to continue. In May alone, the US IG corporate credit market witnessed USD 140 billion in primary issuance. In Europe, supply has been lighter compared to the US, witnessing EUR 40 billion over the same period.
Global retail and institutional investment grade corporate credit flows have continued to tick higher despite tight valuations
What does this mean for fixed income investors?
Demand for IG credit remains robust, supported by strong fundamental and technical factors. Corporate profits continue to grow on the back of the strong growth narrative, driven by the success of the vaccine distribution and monetary and fiscal support, while investor demand has picked up globally, with strong retail and institutional inflows. On the flip side, with spreads close to all-time tight levels, investors should be wary. Given our bias for higher yields, the headwind from tight valuations could outweigh the strong fundamental and technical backdrop.
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