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Everyone seems to love corporate bonds these days. Maybe a little too much.
Demand for the asset class has been extremely robust. Excluding a blip earlier this month, there have been net inflows to credit funds for more than 30 weeks rolling, as investors of all stripes rush to get their hands on the juicy yields on offer in the era of higher-for-longer benchmark interest rates.
Even solid companies are issuing debt with high returns — not great news perhaps for them, but good for investors. And on the whole, it does not appear that companies are struggling with their debt burden.
The New York Fed’s corporate bond distress index has collapsed. Some individual horror stories are still out there but that’s par for the course in corporate debt and broadly, there just is no notable distress. Happy days.
But corporate bond investors are generally a pretty dour bunch, trained to think about what can go wrong. So there’s a good amount of whining in these circles that because of all that demand, yield spreads — the pick-up awarded to investors when they put money at risk with corporate borrowers rather than with governments — have become unusually slender.
US corporate debt with maturity around 10 years now offers some 1.5 percentage point more in yield than the government debt benchmark. It is typically closer to 2 points — a big difference in this market. Counter-intuitively, in both Europe and the US, the longer you look in terms of maturities, the less relative reward you receive.
Some investors don’t feel properly compensated for the risk. “The market is broadly expensive,” said David Knee, co-deputy chief investment officer for fixed income at M&G Investments in London at a recent event. “It’s difficult to find anything that looks really compelling value.” Why bother doing all that homework on a company and how likely it is to let you down, when you can give your money to Uncle Sam for 10 years for a yield of 4.2 per cent?
This view that credit is cooked, a victim of its own success, is pretty widespread. And yet it’s hard to see a convincing case that this will end in tears. “We definitely see that tug of war,” said Sri Reddy, head of client portfolio management at Man Group. Yields are some of the most generous in a decade, he noted, making the asset class highly competitive with stocks, even despite the extra safety bond holders enjoy over shareholders in the event of a company’s failure. To his mind, a laser-like focus on spreads rather than yields may be missing the point. “Company fundamentals are in decent shape,” he said. “Maybe spreads don’t need to widen out.”
This kind of mindset is part of a subtle shift around how fund managers talk about credit. They are much more likely now to talk about yields than spreads. Cynics like me are left wondering whether this is an unconscious group effort to move the goalposts.
“Normally this sentiment concerns me too,” said Joe Davis, global head of the investment strategy group at Vanguard. But we are seeing bigger allocations to credit from investors who would not normally get involved. “At the end of the day, for investors that have a total return target, why would you take on higher equity exposure? Why would you take on more risk?” Davis said. Bonds from highly rated companies can do the job for them.
The rise and rise of the “spread agnostic” investor, interested only in the bumper yield, is a big reason why spreads have collapsed, market specialists say, especially for long-term debt that is sought after by heavy hitting but slow-moving market giants such as pension funds and insurance companies, collectively known as “real money”.
At the riskier end of the market in high yield debt, other technical factors are at play, too. Rating agencies are upgrading more companies to investment grade — a mark of quality — than they are downgrading to the territory often unkindly referred to as junk. If demand holds steady, or grows, and the market shrinks, it doesn’t take a genius to figure out what happens next.
Are some pockets overvalued? Sure. Could stuff go wrong? Naturally. Investors are waiting nervously to see whether the knock administered to European credit by French President Emmanuel Macron’s latest political gamble will prove to be the start of something grim or a rare opportunity to buy the dip, for example. And a proper recession on either side of the Atlantic would of course bite if it were ever to land.
But diehard credit fans are keen to move on from the long-held obsession with spreads, which in any case vary depending on timeframes and quality. Spreads on credit with a more than 10-year maturity, for example, are unusually squished thanks to those yield-hungry real money buyers, while shorter-term spreads are around long-term averages, or even wider in Europe, as Muzinich pointed out at a presentation this week.
“If you were to look at this a year ago, when spreads were wide, people said ‘ooh it’s too risky’ and now they say ‘ooh it’s too tight’,” said Tatjana Greil-Castro at the family-owned credit investment house. “People talk themselves out of credit.” Maybe not for much longer.
katie.martin@ft.com