Profit squeeze: Shoppers walk along New Bond Street in central London. Spreads on US high-grade corporate bonds could tighten to 55 bps. — Bloomberg
LONDON: Corporate-bond valuations are in nosebleed territory, flashing their biggest warning in almost 30 years as an influx of money from pension fund managers and insurers boosts competition for assets.
So far, investors are sanguine about the risk. Many money managers don’t see valuations coming back to Earth anytime soon.
Spreads, the premium for buying corporate debt rather than safer government bonds, can remain low for a prolonged period, in part because fiscal deficits have made some sovereign debt less attractive.
“You could easily make a call that spreads are too tight and you must go somewhere else but that’s only part of the story,” said Vontobel portfolio manager Christian Hantel.
“When you look at history, there are a couple of periods when spreads stayed tight for quite some time. We are in such a regime at the moment.”
To some money managers, high valuations are reason to be alarmed, and there are risks now, including inflation weighing on corporate profits.
But the investors that are buying the securities are drawn to yields that look high by the standards of the last two decades, and are less focused on how they compare with government debt.
Some even see room for further compression. Spreads on US high-grade corporate bonds could tighten to 55 basis points (bps), Invesco senior portfolio manager Matt Brill said at a Bloomberg Intelligence credit outlook conference in December.
They were indicated at 80 bps on Dec 3 or 0.80 percentage point.
Europe and Asia are also approaching their lowest levels in decades.
Hantel cited factors including reduced index duration and improving quality, the tendency for the price of discounted bonds to rise as they come closer to repayment and a more diversified market as trends that will keep spreads tight.
Take BB-rated bonds, which have more in common with blue-chip firms’ debt than highly speculative notes.
They are close to their highest ever share ever of global junk indexes.
In addition, the percentage of BBB bonds in high-grade trackers – a major source of anxiety in previous years due to their elevated risk of downgrades to junk – has been declining for more than two years.
Investors are also focusing on carry, industry parlance for the money that bondholders make from coupon payments after any leverage costs.
“You don’t necessarily need much in spreads to get close to double-digit returns” in high yield, said Mohammed Kazmi, portfolio manager and chief strategist of fixed income at Union Bancaire Privee.
“It’s mostly a carry story. And even if you do see wider spreads, you have the buffer from the all-in yield.”
Tighter spreads also mean that since the financial crisis, the cost of protection against defaults – or at least the price tag of hedging market volatility – has rarely been as low as current levels.
Fund managers have taken advantage of similar periods of cheapness in the past to build up insurance, but so far there hasn’t been enough buying pressure to increase credit default swap risk premiums.
To be sure, the everything rally in spreads has shrunk the gap between stronger and weaker issuers in the credit market.
Bond buyers are getting paid less to take extra risk, while companies with fragile balance sheets don’t pay much above their more solid peers when raising money.
Still, it will take a significant shift in momentum to upend risk premiums.
“While fixed income spreads are tight, we believe a combination of deteriorating fundamentals and weakening technical dynamics would be needed to trigger a turn in the credit cycle, which is not our base case for the coming year,” said Gurpreet Garewal, macro strategist and co-head of public markets investing insights at Goldman Sachs Asset Management. — Bloomberg
