Rising rates can bring challenges to IG corporate credit, but opportunities are emerging as well—particularly given the supportive fundamental and technical backdrop.
Rising U.S. Treasury yields have certainly brought rates to the forefront of investors’ minds. At a high level, rising rates can be challenging for investment grade (IG) corporate credit given the longer-duration of the asset class, and can lead to negative total returns—and indeed, IG corporate bonds returned -4.65% in the first quarter of the year. However, while negative total returns have historically driven retail flows out of IG bond funds, that phenomenon has yet to materialize, with the asset class experiencing inflows in all but two weeks of the quarter. In addition, despite the volatility in Treasury yields, corporate spreads remained stable, finishing the quarter at 91 basis points (bps), close to where they started the year (96 bps) (Figure 1).1
FIGURE 1: IG SPREADS REMAINED STABLE IN THE FIRST QUARTER
Source: Barings. As of March 31, 2021.
Supportive Technicals & Strong Fundamentals
Part of the reason for the stability in spreads is that IG corporates remain well-supported by a strong fundamental and technical backdrop. Outside of hard-hit sectors like airlines and hotels, corporate fundamentals have been relatively resilient over the last year and should benefit as the economy continues to improve going forward. Corporate leverage, while elevated, has remained lower than expected, with a significant portion sitting as cash on company balance sheets. Going forward, one big question is around how companies will deploy this capital. If they use it to pay down debt, leverage may return to more normal levels. We may be more likely to see this among lower-rated BBB companies, in particular, given their higher likelihood of being downgraded to high yield. Single-A companies, on the other hand, may have more room to add leverage and/or pursue growth opportunities.
From a technical standpoint, following last year’s record $2.1 trillion of new issuance, expectations were for a return to more normal levels in 2021. However, issuance surged early in the year—reaching $442.1 billion by the end of March—as a number of companies rushed to the market to try and get ahead of rates potentially rising even further.2 While this resulted in some deterioration in technicals mid-quarter, the supply/demand dynamic has since begun to normalize, for a few reasons. For one, the U.S. Federal Reserve signaled that it would keep interest rates low for some time, which should in turn normalize the pace of issuance.
In addition, institutional demand for U.S. corporate credit has strengthened, particularly from foreign investors in Asia and Europe, given that hedging costs have improved meaningfully—as well as the fact that there is still a significant amount of low or negative-yielding debt around the world. Indeed, for the asset class’ institutional buyer base in particular, rising rates are not all bad. Last year, with both rates and corporate yields near all-time lows, some institutional investors faced challenges in terms of asset-liability matching, leading them to consider allocations to lower-rated, higher-yielding asset classes. As rates have moved higher this year, the resulting incremental yield has rectified this challenge to an extent, leading to a push back into the asset class.
Areas of Opportunity
While it’s hard to argue that spreads will move much tighter from here, the supportive backdrop and continued economic growth should benefit corporate credit going forward, and we expect to see select opportunities in the coming months. One interesting trend is around rising stars, or companies upgraded from high yield to investment grade. Last year, $238 billion was downgraded from investment grade, and this year, we believe many of these companies could just as quickly make a round trip back to IG—in fact, it looks like we may see more upgrades than downgrades on a net basis. This is partly because ratings agencies are giving companies more time to work through the post-pandemic environment. There is also an incentive for companies to either remain in, or get upgraded to, the IG space—namely, the more favorable cost of capital relative to high yield, as well as the access to the capital markets.
Within this universe of potential upgrades, energy stands out from a sector standpoint. Last year, energy companies were hit particularly hard from both COVID and the precipitous drop in oil prices. Natural gas prices were also low, and a number of companies were downgraded as a result. Today, oil prices are sitting around $60 a barrel and natural gas is around $2.50, which is supportive of cash flows. In addition, we have seen greater discipline across the industry, with many companies taking material steps to lower leverage. These factors have already resulted in upgrades this year—natural gas company Cenovus is one example—and in our view could lead to further upgrades going forward.
Looking ahead, given the positive growth outlook for the global economy and the accommodative policy stance from the Fed, IG corporates are likely to remain supported. That said, a number of uncertainties remain on the horizon—from the vaccine rollout to the potential for rates to rise further. In this environment, there may be benefits to looking beyond traditional corporate bonds, particularly in securitized products like collateralized loan obligations (CLOs) and asset backed securities (ABS). ABS, for instance, can offer diversification benefits as part of a broader investment grade allocation due to the diverse scope of the space. CLOs, too, can offer a number of benefits alongside traditional corporate bonds, particularly given their floating rate nature and strong structural protections. However, a credit-by-credit approach rooted in rigorous, fundamental analysis remains paramount to uncovering opportunities across the IG landscape, as well as to avoiding companies that may face greater challenges going forward.
1. Source: Bloomberg Barclays U.S. Corporate Index. As of March 31, 2021.
2. Source: Bloomberg Barclays U.S. Corporate Index. As of March 31, 2021.