IG Credit: Upgrading the Roster
For investment grade (IG) credit, quality may be the name of the game going forward. While the market saw a continuation of its positive second-quarter performance through much of the third quarter, volatility resurfaced at quarter-end.
Nonetheless, IG corporate bonds ended the quarter up 1.54%, despite COVID-sensitive sectors continuing to face greater challenges.1 Market technicals, for the most part, remained supportive. While new issuance surged across both the IG corporate and securitized markets, the heavy supply was met with strong demand—much of which has come from investors looking for yield in a lower-for-longer rate environment. Against this backdrop, spreads remained largely stable.
The volatility that emerged in the last few weeks of September serves as a good reminder of the many unanswered questions likely to play out over the next several months and year. Of those, corporate fundamentals are top of mind for many—particularly amid rising debt levels and falling interest coverage ratios. While adding debt against an uncertain economic backdrop is not without risk, a significant portion of the debt these companies are raising is sitting as cash on their balance sheets—evidenced by the widening gap between IG net and gross debt (Figure 1).
Shorter-term, this suggests that companies have the flexibility to pull multiple levers in the event of future liquidity challenges. Longer-term, however, the way companies service their debt will have significant implications for investors. In part, it will depend on the companies themselves. For instance, as companies issued large amounts of debt earlier this year, debt-to-EBITDA ratios increased. Even though many companies now look quite strong from a liquidity perspective, what they ultimately choose to do (or have to do) with the excess cash on their balance sheets will be heavily influenced by corporate earnings and economic growth. Online retailers, for instance, may very well face a different set of circumstances than travel & leisure businesses.
Figure 1: 12-Month Growth in EBITDA, Total Debt & Net Debt
Source: J.P. Morgan. As of June 30, 2020.
Aside from the technical and fundamental backdrop, there are a number external factors that could impact the markets over the coming months. For one, there are still many questions around COVID, from the potential of a second wave to the timing of a vaccine. The markets seem to be operating under the assumption that a vaccine will come sooner rather than later, so another potential risk going forward is that that doesn’t happen as expected.
The U.S. election is another. Headlines around the election will inevitably influence markets in the short term—after all, markets don’t like uncertainty. However, it is worth noting that in 2016, many market participants anticipated a swift drop in markets in the event of a Trump victory—but the actual response was quite mild, with markets trading down for a very short period and then rallying back. Longer-term, the potential effects of changes to tax policy, corporate policy and foreign policy are less clear.
Related to the election, there is also uncertainty around a U.S. stimulus package. Many market participants anticipated further stimulus in the third quarter, but that didn’t come—and expectations seem to change by the day. This delay contributed to the uptick in volatility toward quarter-end, and could potentially keep markets on edge in the fourth quarter.
Monetary policy—particularly around inflation targeting—has also raised questions recently. Following its Jackson Hole Summit in August, the U.S. Federal Reserve announced a new policy shift that targets an average inflation rate of 2%—suggesting inflation will be allowed to move higher for an amount of time. It’s not clear how this will ultimately play out, or whether the monetary largess of the past six months will actually trigger a bout of inflation, but there will certainly be implications for markets going forward.
Up in Quality
In the remaining months of the year, opportunities will surely arise, but protecting value will also be key. The aforementioned factors have the potential to introduce volatility into the markets—and while we do not expect anything like the liquidity-driven collapse we saw in March, we could see spread weakness. To that end, when it comes to IG markets broadly, we see benefits to upgrading exposure from both a credit and liquidity perspective.
IG corporate bonds look attractive, in our view, particularly considering the strong backstop in the U.S. Federal Reserve—which has made very clear its intentions to do whatever it takes to support the capital markets. We also continue to look for value opportunities in the securitized space. Across asset backed securities (ABS), for instance, high-rated segments of the market such as FFELP student loans continue to look attractive relative to COVID-exposed industries like aviation and auto. Higher-rated parts of the commercial mortgage-backed securities (CMBS) market also look well-positioned to offer value going forward, such as warehouses and data centers.
EM debt is another area we believe looks attractive today, specifically EM hard currency corporates. Many of the issuers in this space are strong companies with global footprints. While they have been slower than their developed market counterparts to recover from the initial shock of the pandemic, many entered the crisis from fairly strong starting points—with significant cash balances and limited capital expenditures. But again, credit selection matters.
The economy, for now, seems to be holding up fairly well. But the recovery thus far has been uneven, and will likely remain bifurcated going forward. With headlines quite likely to drive volatility over the next few months, it is as critical as ever to take a credit-by-credit approach and identify high-quality companies that are well-equipped to weather any coming challenges and thrive beyond today’s events.
1. Source: Bloomberg Barclays U.S. Corporate Index. As of September 30, 2020.