fixed income | june 3, 2021
Focus on Higher-Quality Investment-Grade Corporate Bonds
We are finding opportunities to add yield despite narrow spreads.
Investment-grade corporate bond valuations are expensive, and fundamental and technical conditions in the sector are still positive but becoming more fragile.
Although risks appear skewed to the downside at current valuation levels, we see the potential for the rally in the asset class to continue.
We are still finding opportunities to add yield to portfolios in more liquid, higher-quality segments of the investment-grade corporate market.
Lauren Wagandt, CFA
Co-portfolio manager, Corporate Income Fund
Matt Lawton, CFA
Sector portfolio manager, US Investment-Grade Credit
Investment-grade corporate bond valuations, measured by credit spreads,1 are expensive relative to history, and fundamental and technical conditions in the asset class are still positive but becoming more fragile. At the same time, “fear of missing out” amid an unusually strong economic recovery and massive government stimulus may continue to drive interest in the market, possibly moving credit spreads even tighter. While we are taking a relatively conservative stance toward risk in investment-grade corporates, we are still finding some opportunities to add incremental yield in higher-quality, more liquid segments of the market.
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Credit Spreads at Record Lows After Adjusting for Quality and Duration
Adjusted for changes in credit quality composition and duration2 over time in the U.S. investment-grade corporate market,3 credit spreads are at record-low levels as of mid-May. The difference in spreads between A rated and BBB rated credits is also low, so investing in lower-quality bonds within the sector does not provide much additional spread. Credit curves—the amount of additional spread that may be gained by investing in longer maturities of similar issuer types—are also relatively flat, removing some of the spread advantage of moving to longer-term bonds.
Compressed Spread Differentials
(Fig. 1) Credit spreads for A rated and BBB rated bonds*
As of May 18, 2021.
Past performance is not a reliable indicator of future performance.
A basis point is 0.01 percentage point.
Source: Bloomberg Barclays
*Within the Bloomberg Barclays U.S. Corporate Investment Grade Bond Index
Near-Term Technicals Less Supportive
Technical conditions, which gauge trends in supply and demand, are somewhat less supportive in the near term for investment-grade corporates. Issuance was higher than expected for 2021 through April, although the level of new supply was still down from the same period in 2020 when companies rushed to issue bonds to raise cash amid the onset of the pandemic. We expect merger and acquisition activity to increase as 2021 progresses, potentially adding to supply pressure as acquirers often bring new debt to market to fund their deals.
On the demand side of the equation, foreign flows into the asset class have slowed. However, we think that a material widening of credit spreads would draw renewed demand into the investment-grade corporate market to try to take advantage of the more attractive valuations. We observed this behavior in March, when credit spreads widened modestly but then narrowed fairly quickly as buyers moved back into the market. The asset class still appears to provide attractive yields for global buyers, which we believe should help limit some of the downside risk.
Fundamentals Still Improving but Past Peak
Fundamentals in investment-grade corporate issuers are still improving, supporting their ability to maintain their credit ratings, but the upward trajectory in balance sheet strength now appears to be past its peak. After the second quarter of 2021, we expect the rate of growth in sales and earnings for companies in the Standard & Poor’s 500 Index (many of which issue investment-grade bonds) to decrease from the robust levels seen in the first half of the year.
In 2020, investment-grade corporate issuers substantially boosted their cash reserves by issuing new bonds. Our investment-grade corporate credit analysts expect excess cash levels of the companies that they cover to fall by about 80% from the end of 2020 to the end of this year as companies put their cash stockpiles to work. We have also noticed that more issuers have started to use their cash reserves to buy back stock or increase dividends rather than making capital investments or fortifying their balance sheets, helping to support their equity prices.
Opportunities to Add Yield in Higher-Quality, More Liquid Segments
With these risk factors in mind, we also recognize that the current economic expansion is atypically strong and that the amount of monetary and fiscal stimulus in the economy easily surpasses any past period. Although risks appear skewed to the downside at current valuation levels, we see the potential for the rally in the asset class to continue. As a result, we favor maintaining exposure, even at the current narrow credit spreads, while having a relatively conservative stance in investment-grade corporate credit.
We still see opportunities to add yield to portfolios in more liquid, higher-quality segments of the investment-grade corporate market, including credits in industries such as banks and telecommunications. We also tend to prefer short- and intermediate-term maturities, which typically offer more spread relative to their interest-rate risk. This is particularly true in the current environment, where longer maturities provide only limited additional expected compensation for taking on more risk and entail considerable duration risk.
We have also found that indexes of credit default swaps,4 known as CDX, tend to be more liquid and attractively valued than the underlying cash bonds and can be useful tools for efficiently adding or removing exposure to investment-grade corporate credit.
What We're Watching Next
The potential for higher inflation as the economy more fully reopens has received considerable attention in the media. While inflation erodes the value of bond coupon payments over time, it can also eventually drive labor costs higher. This can crimp profit margins at investment-grade corporate issuers, weighing on their credit quality.
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Key Risks—The following risks are materially relevant to the strategy highlighted in this material:
Fixed income securities are subject to credit risk, liquidity risk, call risk, and interest rate risk. As interest rates rise, bond prices generally fall. Investments in high yield bonds involve greater risk of price volatility, illiquidity, and default than higher-rated debt securities. Derivatives may be riskier or more volatile than other types of investments because they are generally more sensitive to changes in market or economic conditions; risks include currency risk, leverage risk, liquidity risk, index risk, pricing risk, and counterparty risk.
1Credit spreads measure the additional yield that investors demand for holding a bond with credit risk over a similar-maturity, high-quality government security.
2Duration measures a bond’s sensitivity to changes in interest rates.
3As measured by the Bloomberg Barclays U.S. Corporate Investment Grade Bond Index.
4A credit default swap involves regular payments from the buyer to the seller in exchange for repayment of principal value to the buyer if the issuer experiences a credit event such as default.
Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
The views contained herein are those of the authors as of May 2021 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation concerning investments, investment strategies, or account types, advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Please consider your own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Actual future outcomes may differ materially from estimates.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.
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