THE CROWDED CORPORATE CREDIT TRADE / THE FINANCIAL TIMES OP EDITORIAL

The crowded corporate credit trade

With rates set to fall, are corporate bonds too expensive?

Ethan Wu

© FT montage

Everyone knows that bonds are back

At a first pass, the risk-on feeling in corporate credit makes sense. 

Bond investors are chiefly concerned with two types of risk: credit and duration. 

The toughest environment for corporate bonds is one where the economy looks wobbly while rates are rising, raising the lethal combination of higher defaults and declining prices (which move inversely to yields). 

This was the set-up in 2022, a year in which global bonds lost 31 per cent. 

In 2024, the prognosis is quite the opposite. 

Soft landing and falling rates should be a boon for bonds, lowering recession risk while delivering a capital gain. 

Calmer inflation, eroding less of bonds’ fixed nominal coupons, helps too.

Markets have gotten the message. 

High yield spreads over Treasuries are tight, at levels consistent with boom times:

The story in investment grade is much the same. 

As my colleague Harriet Clarfelt has reported, roaring investor demand has fuelled a record IG issuance wave, concentrated largely in banks and financials. 

IG spreads are under 1 per cent:

Heightened investor interest is perfectly reasonable given the macroeconomic backdrop. 

But it gives me some pause. 

High-yield bonds returned a remarkable 13.5 per cent in 2023, in part because too much recession risk had been priced in and investors who took risk were well compensated. 

That is not true today. 

Is corporate credit too crowded?

For a gestalt image, start with the Bank of America fund managers’ survey. 

The latest edition for January shows investors’ overweight position on bonds at around two standard deviations above the 20-year average (it doesn’t distinguish between Treasuries and corporate credit):

But on a month over month basis, investors have been paring back their bond exposure:

In a recent market outlook, Anne Walsh of Guggenheim Partners makes the case that, for a sufficiently careful investor, there’s money to be made in HY. 

She argues that credit markets are becoming steadily bifurcated between companies who will benefit from rate cuts on the margin, and those whose balance sheets will struggle in the new 2-4 per cent yields environment.

The grey bars in the chart below show interest coverage ratios for single-B (mid-junk) borrowers under different interest rate scenarios. 

Markets expect the Fed to lower rates from 5.5 per cent today to 4 per cent at the end of 2024. 

If that holds, the median mid-junk borrower would see its interest coverage ratio (ebitda/interest expense) rise from 3.1x to 4.3x:

That’s a big improvement!

It is an average, though. 

Plenty of weaker credits are out there, and tight credit spreads mean bad selection can significantly dent returns. 

Walsh flags weakness among smaller companies in the leveraged loan market, with interest coverage among the bottom quartile of issuers (measured by ebitda) falling below 1x. 

Even still, the appeal of fishing for good credits is clear. 

Here’s Walsh:

The primary factor supporting the credit opportunity narrative is the current allure of all-in credit yields. 

Over the last 15 years, corporate bond and bank loan yields have only reached these high levels during severely adverse market environments…

While we are monitoring [rising bifurcation between large and small companies], we do find many opportunities in smaller companies with good fundamentals and healthy balance sheets. 

In our experience, this cohort often comprises names less covered by other research analysts . . . 

Their spread and yield pick-up over larger borrowers typically compensates for credit and liquidity risks.

Greg Obenshain, head of credit at Verdad Capital, makes the counterpoint, arguing in a recent note that high all-in yields can be deceptive “fool’s yields”. 

The chart below illustrates. 

The dotted blue line shows the hypothetical returns on HY bonds from collecting publicly listed yields. 

But that assumes no defaults; in reality high absolute yields don’t dependably translate to realised returns. 

The solid blue line shows actual returns on HY, which broadly tracks double-B bond yields (solid black), the highest-quality rung of HY. 

The gap between dotted and solid lines shows the impact of defaults:

The punchline: “The lower-yielding, higher-quality BB index is a better estimate of actual returns. 

We believe it is the best you are likely to do in liquid corporate credit.” 

If Obenshain is right, today’s 6.2 per cent yields on double-B’s look reasonably attractive, but a far cry from the bumper year for bonds in 2023. 

Recession, or even a slowdown, is the main risk, especially to lower-quality credit. 

Walsh concedes that markets are “underappreciating still-elevated recession risks”, and she is hardly alone in warning about complacency. 

So far, growth has been steady and any slowing has been gentle. 

But if that changes, optimistic valuations mean little room for error.