While uncertainty remains around rates and inflation, opportunities continue to emerge across IG credit, including in areas outside of traditional corporate bonds.
Investment grade (IG) corporate credit markets regained ground in the second quarter as U.S. Treasury yields stabilized. While the possibility of higher rates remains top of mind for many investors—particularly with the Federal Reserve’s hawkish pivot in June—performance for the quarter was positive, with corporate credit returning 1.63%.1 Amid ongoing optimism around economic growth and the rollout of vaccinations, corporate spreads continued to tighten, finishing the quarter at 80 basis points (bps), roughly 16 bps tighter than where they started the year.
FIGURE 1: IG SPREADS HAVE CONTINUED TO TIGHTEN
Source: Barings. As of June 30, 2021.
Improving Credit Metrics
From a fundamental standpoint, corporate credit metrics continue to improve. As company earnings have strengthened, debt growth has simultaneously slowed, resulting in a decrease in corporate leverage from the post-pandemic peak. While we continue to monitor how companies are deploying the cash sitting on their balance sheets, we believe most have been prudent and, in many cases, are using the cash to pay down debt. Dividends and share buybacks, likewise, have been largely in line with EBITDA growth. And while M&A has certainly increased, particularly in the energy sector, much of it has been equity-financed rather than debt-financed, which has been positive for debt holders.
Following last year’s record $2.1 trillion of new issuance, expectations were for a return to more normal levels this year. However, while issuance has moderated somewhat, it has remained quite strong relative to history—reaching $835 billion as of quarter-end—and continued to beat monthly expectations through June.2 Despite the elevated issuance, heavy supply was met with strong demand and easily absorbed by the market. Much of the demand came from overseas investors, particularly in Europe and Asia, who continue to face difficulties given the significant amount of low or negative-yielding debt around the globe. In fact, as rates and corporate yields hovered near all-time lows last year, some of IG corporate credit’s institutional buyer base was forced to consider allocations to lower-rated, higher-yielding asset classes. As rates moved higher earlier this year, many of these investors returned to the asset class to capitalize on the resulting incremental yield—a push back we expect to continue in the second half of the year, particularly as corporate pensions look to move out of equity and into longer-dated debt.
The improving economic backdrop should continue to benefit corporate credit, and we expect to see select opportunities emerge in the coming months. Rising stars, or companies that look poised to migrate from high yield to investment grade, is one area of the market we continue to monitor. Much of this opportunity stems from the roughly $238 billion of so-called fallen angels that were downgraded from investment grade last year as the pandemic took hold—including companies like Kraft Heinz, Ford and Occidental Petroleum. While some of these companies could take several years to return to IG, there is certainly an incentive to do so in the form of more favorable costs of capital relative to high yield, as well as access to the capital markets. Shorter-term, energy companies in particular stand out as potential upgrade candidates, with some having already made the transition this year. There are also a number of companies in the high yield space that were not fallen angels but that have improving credit metrics and could be potential rising stars. Netflix is one example, as is meat processing company JBS.
With rising rates potentially on the horizon, and given current spread levels, there are also benefits to considering shorter-duration strategies, as well as areas beyond traditional corporate and government bonds. One area where we’re currently seeing attractive value is in securitizations—specifically investment grade-rated CLOs and certain parts of the asset backed securities (ABS) market. ABS, for instance, can provide considerable diversification as well as the potential for attractive risk-adjusted returns. Collateralized loan obligations (CLOs) also offer potential benefits given their floating rate coupons and lower sensitivity to rising rates. We also see select opportunities in emerging markets corporate debt, which tends to be shorter in duration than developed market corporates and often trades wider given the idiosyncratic risks across the EM landscape.
As we look ahead to the coming months, questions remain, not only around inflation and rates, but also around COVID, and whether some of the virus’ new strains could threaten economic growth. In this environment, we believe a multi-credit approach that looks broadly across the investment grade landscape can be particularly beneficial. Because multi-credit strategies tend to be benchmark agnostic, they can give portfolio managers the flexibility to pursue the most attractive relative value opportunities as they emerge across asset classes, sectors and geographies—resulting in a diversified approach to credit that can potentially deliver more attractive risk-adjusted returns over time.
1. Source: Bloomberg Barclays. As of June 30, 2021.
2. Source: Bloomberg Barclays. As of June 30, 2021.