A year on from the height of the COVID-19 crisis, credit spreads have returned to their pre-pandemic tight levels. Does this present an asymmetric return profile for corporate bonds?

The scope for further spread tightening is limited, in our view. The last time spreads traded around these levels was in January 2018, and only for a few weeks. Prior to that we need to go back to a period before the global financial crisis (GFC) from mid-2003 to mid-2007¹. This does create an asymmetric risk profile in terms of spread moves, especially over the medium term, but the world feels a very different place now than prior to the GFC. In the first place, we have had an unprecedented amount of monetary and fiscal stimulus measures that have helped support markets throughout this crisis, and which averted what could have turned into a more widespread and systemic disruption to credit markets.

Secondly, while overall corporate indebtedness has risen there has been a shift from property and mortgage lending towards loans to the corporate sector. Also, company fundamentals were in good shape going into the crisis, and those companies that had taken on more leverage tended to be the ones that could better afford it. In that sense, the systemic risk to the financial system is lower than it was prior to the GFC. It is also worth noting that interest coverage ratios improved following the GFC, while in the US corporate taxes under the Trump administration fell, thus generally improving companies’ ability to repay their debt. In a low interest rate environment this debt looks more affordable, although of course this could change over time. While many companies also took advantage of falling interest rates in response to the pandemic to issue debt, resulting in a bumper year for gross issuance in 2020, they have also been relatively conservative with their use of proceeds. The fact that companies built up their cash reserves in response to the COVID-19 liquidity crisis certainly helped mitigate a worse deterioration in a number of credit metrics that resulted from the pandemic.

All things considered, while one has to acknowledge tight valuations at current spread levels, calling the exact timing of any spread widening is challenging. We still have very strong monetary and fiscal support as well as a lot of liquidity in the system. Demand for the asset class also remains strong, creating a positive technical backdrop. It is therefore difficult to be significantly underweight investment grade corporate bonds given the strength of the market technicals and improving economic outlook.

However, now is not the time for complacency, but rather selectivity. This is where an active approach, backed by deep and fundamentally driven research to identify those companies that have taken on too much debt versus those capable of withstanding any deterioration in their operating environment, can add value.

 

1 . As at May 2021 as measured by the Bloomberg Barclays Global Aggregate Corporate Index. Source: Bloomberg Barclays.

 

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