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US corporate debt: opportunity and risk in a post-COVID world
James Blair
Fixed Income Investment Director
KEY TAKEAWAYS
  • We believe central bank stimulus has reduced the probability of stronger investment-grade bonds being overwhelmed by further bouts of market volatility. 
  • Fresh US interest-rate cuts should also encourage European and Asian investors back to US corporate bonds, as hedging back to their home currency now produces a positive yield. 
  • Recent market stress has left a number of BBB issuers at risk of market downgrades, and seen a rise in systemic risks, such as a lack of liquidity in both the foreign exchange (FX) swap market and exchange-traded funds (ETFs). The impact of these issues on US investment-grade credit could worsen if market volatility rises in the months ahead.

Has central bank action made corporate bonds a more attractive long-term proposition for investors? 


We believe it has. Indeed, the main positive driver of macroeconomic fundamentals across markets today is accommodative monetary policy. Investors globally have welcomed the policy response to the COVID-19 outbreak, as it has been swift and extensive – unlike the global financial crisis. Measures such as liquidity provision, interest-rate cuts, bond buying and lending facilities have worked hand in hand with unprecedented government stimulus measures. This has provided near-term economic and market relief from the severe effects of the COVID-19 outbreak and subsequent lockdowns seen in many cities and countries. 


These measures have also lessened the effects of sovereign risk and interbank funding stress. But, more importantly, they have significantly reduced the nearterm probability of systemic risk overwhelming stronger credit issuers in investment-grade corporate markets, as well as the potential for negative repercussions to linger over the broader market for a longer period of time.


As a result, investors can continue to focus on the key drivers of investmentgrade corporate credit spreads, namely macroeconomic fundamentals, corporate fundamentals and market technicals.

 

Has the changing landscape for hedging benefited the US corporate bond market in the wake of central bank action? 


Due to the Federal Reserve’s (the Fed) interest-rate cuts in response to the COVID-19 crisis, the cost of hedging a US dollar exposure to other currencies, including the euro, sterling and yen, has fallen dramatically. This is important, because over the past five years, and until 2019, non-US dollarbased investors looking to hedge fixed-income investments to their home currency have often shied away from allocating to US dollar bonds, due to its punitive hedging costs. Today, however, buying a US 10-year Treasury note and hedging back to the yen gives investors a positive yield for the first time since October 2018. In that year, hedging costs were as high as 300 basis points on an annualised basis. As of the middle of July, with the reduction in the interest differential between the US dollar and the yen, that cost has fallen to around 50 basis points. For a euro-based investor, the corresponding figures are 350 and 80 basis points, respectively1.


There are also signs that this could be a long-term trend. At the June US Federal Open Market Committee meeting, the ‘dot plot’, which depicts interest rate expectations of the voting members, revealed the committee’s expectations for low US interest rates through 20222. This may serve to keep hedging costs low for some time.

 

Regardless of central bank actions, what risks remain for the US corporate bond market? 


Corporate fundamentals will continue to face near-term headwinds from the sharp slowdown in economic growth and its subsequent impact on earnings, cash flow and leverage. COVID-19’s inherent uncertainty adds another layer of volatility, given the potential for further waves of infection and the timeline for the development of successful vaccines and therapeutics. And although market technicals have benefited from central bank and government intervention – particularly around trading liquidity, supply/demand flows and capital markets access – credit-rating downgrades will continue to weigh on investor sentiment.

 

What distinguishes the US corporate bond and makes it well suited to the current market volatility? 


Of the world’s investment-grade corporate bond markets, the US has the broadest, in terms of sectors; the deepest, in terms of names per sector; and the most liquid, in terms of trading volume. And with a market value in excess of US$6 trillion and more than 6,000 issues outstanding, the US market is more than double the size of the euro market, which is the second-largest in the world, at €2.5 trillion (or US$2.8 trillion equivalent) and with 3,000 issues3. Emerging markets lag both the US and euro markets in terms of investment-grade debt, where high yield makes up around 30% to 40% of the market4.


 

 

1. Source: Capital Group. As at 31 July 2020.


2. Source: U.S. Federal Reserve. As at 30 June 2020.


3. Source: Bloomberg Barclays. As at 31 July 2020.


4. Source: J.P. Morgan, Bloomberg Barclays. As at 31 July 2020.


 


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 high-yield securities; emerging markets are volatile and may suffer from liquidity problems.


James Blair is a fixed income investment director at Capital Group. He has 28 years of industry experience and has been with Capital for two years. He holds a master's of commerce from the University of New South Wales, Australia and a bachelor's degree in business from the University of Technology, Sydney. James is based in Singapore.


 

Past results are not a guarantee of future results. 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. This information is not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. All information is as at the date indicated unless otherwise stated. Some information may have been obtained from third parties, and as such the reliability of that information is not guaranteed.