IG Credit: Can the Strong Performance Continue?
Despite the historic events that occurred in 2020, investment grade (IG) credit ended the year in strong positive territory, benefitting from lower interest rates as well as a flight to quality amid heightened volatility. IG corporate bonds delivered a total return of nearly 10% through year-end as investors—thanks to monetary support and the release of the COVID vaccine—largely shrugged off concerns around rising virus cases and the possibility of additional consumer restrictions. Corporate spreads continued to tighten during the fourth quarter to finish the year at 96 basis points (bps), very close to where they started, despite peaking at 393 bps in March 2020.1
Figure 1: IG SPREADS HAVE EXPERIENCED A STRONG RECOVERY
Source: Barings. As of December 31, 2020.
Indeed, with the prospect of many Americans being vaccinated during the first half of 2021, investors in dollar-denominated corporate credit appear to have set their sights on the months and year ahead.
Positives and Negatives
If all goes to plan with the vaccine, there is a good chance the economy could meaningfully reopen during the second half of 2021, and the fundamental picture for most companies could improve accordingly. Corporate leverage, while at all-time highs, has remained lower than initially feared—and a significant portion of the debt that companies have raised is sitting as cash on their balance sheets, meaning net leverage, in particular, has risen less substantially. Going forward, if companies are prudent, and use the cash on their balance sheets to pay down debt they no longer need, we expect leverage to trend toward more normal levels.
FIGURE 2: 12-MONTH GROWTH IN EBITDA, TOTAL DEBT & NET DEBT
Source: J.P. Morgan. As of September 30, 2020.
From a technical standpoint, as companies bolstered liquidity after the onset of the pandemic, credit issuance skyrocketed to more than $2 trillion ($1 trillion net)2 as companies capitalized on the government support. Despite this surge, the heavy supply was met with strong demand, which was easily absorbed by the market. The market’s ability to digest this large supply was due in large part to increased demand from overseas investors, as hedging costs improved meaningfully and the amount of negative yielding debt around the globe rose significantly—which by some estimates is upward of $18 trillion.3
With record levels of cash on company balance sheets, and the prospect of a recovery on the horizon, supply forecasts for 2021 are significantly lower. While we expect gross issuance to fall somewhere between $1.2 and $1.3 trillion, net issuance could fall further below historical averages, to as low as $300 billion—which, in our view, would remain supportive of spreads.4
On the negative side, the second half of the year could bring a reversal of some of the supportive trends we saw in 2020. For instance, as the economy opens back up, investors that gravitated toward IG as somewhat of a safe haven could begin allocating away—and toward higher-yielding or riskier asset classes. An improved economy could also reduce the perceived safety net provided by the U.S. Federal Reserve (Fed). Ultimately, this could lead to underperformance and spread widening, particularly in the lower-rated parts of the IG market.
Interest rates are also top of mind for many IG investors. Although the Fed has made clear its intention to keep interest rates low in the near term, additional stimulus and an improvement in the economy could lead to rising expectations around an increase in rates. At a high level, rising rates are challenging for IG corporate credit, and would likely lead to negative total returns for much of the asset class, particularly if spreads remain range-bound. This in turn could potentially drive retail flows out of IG bond funds—although it is worth noting that the retail buyer base is a relatively small component of the IG market.
The picture is slightly more nuanced, however, given that IG credit has different and multiple buyer bases—and to that end, there are also potential positives that could come out of an increase in rates. For instance, if rates reset to a higher level, the resulting incremental yield could present a potentially compelling opportunity for investors with long-dated liabilities, such as insurance companies and pension funds. If spreads remain stable, this could ultimately lead to a meaningful push back into IG corporate credit.
Given the supportive fundamental and technical pictures, spreads could very well tighten this year as many forecasts suggest. In this environment, one way to take advantage of tightening spreads is to buy higher-beta credits that have not yet recovered. In the IG corporate space, for instance, we continue to see value in BBBs with solid fundamentals that look well-positioned to weather an extended period of COVID-related uncertainty.
There are also potential benefits to reducing duration and moving up in quality. Outside of IG corporate bonds, for instance, higher-rated segments of the asset-backed securities (ABS) market, such as FFELP student loans, continue to look well-positioned—as do parts of the commercial mortgage-backed securities (CMBS) market, which are less sensitive to the path of the virus, such as warehouses and data centers. Collateralized loan obligations (CLOs) may also offer potential benefits going forward, in our view, particularly the AA and A parts of the capital structure.
As we look ahead to the coming months, it is worth reiterating that questions remain around the deployment and acceptance of the vaccine. Although we believe there is room for optimism, we are not necessarily out of the woods yet. In this environment, a credit-by-credit approach remains critical—not only to capturing upside and identifying companies that are equipped to weather near-term challenges, but also to avoiding those that may face greater difficulties down the road.
1 Source: Bloomberg Barclays U.S. Corporate Index. As of December 31, 2020.
2, 3, 4 Source: Bloomberg Barclays Indices. As of December 31, 2020.