After risk assets staged an impressive retracing of the stark March sell-off in April 2020, non-US dollar investors seeking to diversify their corporate bond holdings should consider revisiting the potential benefits of an allocation to US dollar investment grade corporate bonds. In this paper, we discuss current market conditions and introduce the Capital Group US Corporate Bond strategy.

 

In the last five years and until 2019, non-US dollar-based investors with the requirement to hedge fixed income investments to their home currency have often shied away from allocating to the US dollar corporate bond market due to punitive hedging costs. With the emergency interest rate cuts by the US Federal Reserve (Fed) amid the COVID-19 crisis, hedging costs to euro, sterling and other non-US dollar currencies have fallen dramatically. One of many reasons to take another look at the broadest, deepest and most liquid corporate bond market in the world.

After a month of turmoil for credit markets from late February to late March 2020 when spreads peaked on 23 March¹, the Fed and subsequently other central banks, including the European Central Bank (ECB) and the Bank of England (BoE), stepped in to avert a financial meltdown. With unprecedented asset purchase programmes that were further expanded in April, central banks backstopped financial markets, and risk assets including corporate credit staged an extraordinary comeback. During the sell-off weeks, US dollar investment grade (IG) credit significantly lagged their euro IG counterparts, leading to a widening of the spread between the two markets to 130bps — a level only seen during the global financial crisis.²  

 

Chart 1: Difference between US and European investment grade OAS

Past results are not a guarantee of future results.

Data as at 5 May 2020. Sources: Bloomberg Barclays US Corporate Bond Index and Blomberg Barclays Euro Aggregate Corporate Index

 

Subsequently, and after the announcements of the Fed’s corporate bond purchase programmes and their expansions in April to include fallen angels (bonds that have been downgraded from investment-grade to junk bond status) and exchange-traded funds (ETFs), this spread converged back to more normal levels. Questions that arise for investors now are, firstly, is this rally in corporate spreads sustainable and secondly, why should non-US dollar-based investors favour US dollar bonds over their domestic markets?

 

Is this rally in corporate spreads sustainable?

Corporate bond spreads have narrowed significantly since the wide levels reached in March and the scale of the recovery has restored some of the value lost in the sell-off, retracing more than half the widening seen from the spread lows at the beginning of the year. The option-adjusted spread (OAS) for US IG corporates on the index level stands at 208 bps at the time of writing,³ retracing more than 160bps from the 373bps peak reached on 23 March, so almost 60% of the widening in February/ March in less than six weeks. This was an extraordinary sell-off, but also recovery. In comparison, during the global financial crisis (GFC) in 2008/09, it took the US corporate bond market almost six months to retrace 60% of the widening seen at the height of the crisis. The reason for the speedy recovery during the COVID-19 crisis so far was the unprecedented and swift response of the Fed offering support as the lender of last resort and the inclusion of fallen angels in their purchase programmes. With this, the central bank eliminated investors’ concerns about refinancing risk for the BBB-segment of the USD IG market. 

Looking at history, a corporate OAS level of over 200bps has been a rare event. Over the past 30 years, the spread has been above this threshold for more than four weeks only in three periods: in 2002, 2008/09 and 2011/12. Indeed, a spread of 208bps places the valuation of the market in the 86th percentile, with 0 being the richest period and 100 the cheapest.⁴  

1. Source: Bloomberg Barclays US Corporate Bond Index

2. Sources: Bloomberg Barclays US Corporate Bond Index and Blomberg Barclays Euro Aggregate Corporate Index. Spread between the two indices reached over 130bps between 20 and 23 March 2020.

3. As at 15 May 2020. Source: Bloomberg Barclays US Corporate Bond Index

4. Bloomberg Barclays US Corporate Bond Index. The percentile calculation is from August 2000 (since daily data is available) to date based on daily observations.

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease.
• Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or highyield securities; emerging markets are volatile and may suffer from liquidity problems.