Global Head of Fixed Income Jim Cielinski explains why we have a constructive view of today’s bond markets and where we see opportunities in the current environment.
- Many bond investors may have a “glass-half-empty” perspective on today’s bond markets as they anticipate a world of rising inflation, higher interest rates and tight corporate bond spreads.
- We take a more constructive view, with various signals – moderating inflation, a supportive central bank, low real yields and low default rates – pointing to low distress in credit markets.
- While neither the income nor the diversity offered by bonds may be as high as in the past, they continue to play an important role in a diversified portfolio.
In recent months, macro and microeconomic fundamentals have broadly improved as the market anticipated, while longer-maturity U.S. Treasury bond yields have fallen and credit markets have generally rallied. Economic growth, globally, is accelerating and corporate bond markets are largely priced for it to continue. This begs the question: What could go wrong and how might fixed income markets respond?
Let’s start with inflation. Recent inflation data out of the U.S. has been concerning, with the year-on-year U.S. Consumer Price Index (CPI) surging 5.4% – the largest since 2008. But there are reasonable and understandable factors behind the recent surge. The much-discussed “base effect” is one. Supply bottlenecks creating price pressures is a second. Low inventories combined with a surge in spending from pent-up demand is yet another. But all of these indicators are essentially cyclical. Bottlenecks clear, inventories rebuild, and pent-up demand is relieved.
To have sustained inflation – the kind that should worry the Fed and the markets – there must be a persistent push on costs. In our view, the key variables for that to occur are wage pressures and private credit creation. Spending on ever-higher priced goods is not sustainable without commensurate wage increases. Both wages and home prices could end up fueling more sustained inflation, but it is not yet clear whether that will ultimately be the case.
The U.S. still has a large output gap. There is spare capacity in the labor market, wages have shown inconclusive evidence of turning to a sustained trend higher, and home prices are heavily influenced by demographic changes post-COVID. And while fiscal policy temporarily replaced lost income, it is now fading at the near-perfect time as the economy returns to “normal”.
The Fed Is Back in Play – Should We Be Worried?
In June, the Federal Reserve (Fed) appeared more hawkish in tone, with more Federal Open Market Committee (FOMC) members suggesting rate hikes in 2023. However, volatility in equity markets did not spike, and longer-maturity Treasury yields rallied. The Fed did put something of a lid on the more aggressive “reflation” trades and made its eventual reduction in quantitative easing (the direct purchase of bonds in the open market) a topic of conversation. But bond market volatility went down, not up, because the Fed’s evolving stance is both consistent with market data and sends the message that they will be incremental in their actions.
We think the Fed will continue to display patience, will err on the side of stronger economic growth and will not look to “preemptively” raise interest rates. With the Treasury market pricing in future inflation over 2%, it seems the Fed and the bond market are on the same page.
Do Corporate Bond Valuations Make Sense?
An economic recovery is reflected in major market prices. Global equities are up strongly, with some markets reaching new highs. Commodities have rebounded strongly from the recession lows. The price of oil is up 65% from a year ago and trading above the level at the start of 2020, while copper prices have climbed 43% in the past year.1 As such, it is no surprise then that risk assets within fixed income are exhibiting similar strength, with corporate bond spreads at or near all-time lows. Rallies of these magnitude are not uncommon in the early phase of an economic recovery. But where do they go from here? Where are we now in the business cycle? Do these aggressive valuations make sense at this stage?
It is unusual for spreads to be near cyclical lows so early in a recovery, and even more unusual to be near historic lows so early in a recovery – but these are unusual times. Most recessions see a permanent loss of income and jobs. But in the 2020 recession, the government replaced a great deal of the lost income almost immediately. Economic output ground to a halt, but consumer’s confidence in their future income did not.
There are also, in our view, structural reasons for credit spreads to trade tighter relative to their history. Across the globe, excess savings have increased demand for investments. Many investors and institutions bemoan the lack of yield available in bonds. Some (like banks and insurance companies) have capital constraints that give them little choice but to keep buying bonds. Finally, the Fed’s own bond purchasing programs have contributed to demand and injected historic levels of liquidity into the market. Put simply, that liquidity – that money – has to go somewhere, and the financial markets are the easiest and quickest way to put it to work.
Valuations May Be High, but the Risk of a Credit Crisis Is Low
A glance at bond prices might suggest that the upside in the current economic cycle is over. But timing the market is notoriously difficult. We think it can be helpful to step back and look at what, albeit historically, creates the conditions for credit markets to widen materially. In our experience, three things are needed to create the potential for a significant, cyclical correction in the corporate bond markets: high debt loads, restricted access to capital and an exogenous shock to cash flows. If all three are present, the chance of a crisis is highly likely.
Today, only debt loads are an issue. The amount of corporate borrowing is high and has risen. But it is important to adjust the volume of debt by its cost. When borrowing costs are low, companies typically opt to borrow, assuming the cost of taking on the debt is not greater than their ability to generate the revenue to pay it. Today, we see little to suggest that companies are likely to have a debt problem. Furthermore, between zero interest rates, quantitative easing, record bond issuance and direct fiscal programs to support companies, it is hard to find evidence that companies are struggling to access capital. Finally, there was an exogenous shock (COVID) to cash flows that triggered the correction in 2020. But net earnings are now rising sharply as revenues recover, and this is feeding into healthier cash flows.
This is all to say that, of the three conditions we view as being required for a credit crisis, perhaps one-half of those is currently detectible. While we can debate the meaning of current valuations and how best to time the market, it is hard to argue that corporate credit could be at a cyclical turning point.
The Relative Value in High Yield
As interest rates have fallen over the last decade and the cost of borrowing has declined, companies have grown more comfortable with lower credit ratings. Before the Global Financial Crisis (GFC), around one-third of the corporate bond index was rated BBB. Today, it is just above half. So while corporate bond spreads are trading near their 2007 lows, today’s investment grade index is lower quality. If we adjust for this migration toward lower aggregate credit risk, corporate credit spreads today are trading well through the 2007 lows.
However, the opposite is true in the U.S. high yield corporate bond market, where the average credit quality has been stable to improving. Current spreads are significantly wider than the lows in 2007 and are even wider on a credit-adjusted basis, where there is a clear disparity between investment grade and high yield. For investors who agree with our assessment that the credit cycle shows little signs of changing direction, who believe the Fed is likely to remain supportive, and who are eager for yield, the high yield markets of the world may merit a closer look.
Absolute Yield Levels Are Low, but So Are Expected Defaults
Default rates on high yield bonds largely follow the credit cycle. But all the unique factors affecting the current cycle are also changing the likelihood of future defaults. JPMorgan is currently forecasting a default rate of only 0.65% for the U.S. high yield market in 2021.2 To get a sense of how historic this forecast is, the high yield market has a theoretical “frictional default rate”, which is the rate at which companies are likely to default regardless of the cycle. The idea of a frictional default rate is that, no matter how positive the environment, some percentage of high yield bonds will run into trouble. While estimates vary, JPMorgan’s current forecast default rate is around half the frictional default rate. This is clearly a unique situation and leads us to believe that high yield bonds could well settle into a period of record-low defaults for the foreseeable future.
Low Real Rates Are Helping
The conundrum of how we can have low government bond yields while concurrently being afraid of inflation reflects the puzzle of how we can have (very) low real yields. (Real yields are yields taking into consideration expected inflation. While theoretical, they are the “real” yield you would get after inflation erodes the value of some of your income). With inflation expectations already elevated and the nominal 10-year government bond yields averaging around 1.4% in the last couple of months, the real (nominal minus inflation) yield is around -1.1%. This level of negative real yields is relatively new to U.S. investors but has been around for a decade in Europe.
Real 10-Year Government Bond Yields
Source: Bloomberg, generic 10-year real yields, 21 July 2006 to 21 July 2021.
With real rates negative, many companies can essentially borrow at rates which are below their expected revenue growth. To put it plainly, it would take an unusual number of management mistakes to fail when you have access to capital and can borrow at current rates. A sustained move higher in real yields would change this, but it would require a reversal in long-term structural factors that have depressed equilibrium rates, such as excess global savings, aging demographics and technological productivity. For now, these structural deflationary trends remain intact. Lower real yields seem to be just part of the new reality.
Is There Now a Fed “Put” for Corporate Debt?
Central bank policy evolves over time but the trend has been to provide ever greater support for financial markets. The famous Greenspan “put”3 gave confidence to equity markets that there was some level of drawdown that the Fed would not tolerate. If things got too bad, Alan Greenspan (Fed Chairman at the time) would bail them out.
Subsequent central bankers echoed this approach, extended it to the banking system, and “quantitative easing” became acceptable. Central banks around the world engaged in buying corporate bonds in addition to government bonds. After COVID-19, the Fed even began buying high yield bonds, albeit on a small scale.
Default Cycles Are Less Pronounced
Central banks are fearful of high debt loads and their ability to engineer an orderly unwind
Source: Deutsche Bank, Moody’s, 1981 to 2020, Deutsche Bank Default Study, 26 April 2021. Default rate per calendar year and average default rate over specific time frames.
Recessions, from a central banker’s perspective, are healthy. Companies with poor business models or too much debt are weeded out. But the COVID-19 recession introduced Fed-sponsored capital programs to lend to troubled companies. The result was even higher corporate debt levels. Will the Fed provide even more support in the next crisis? In other words, is there a corporate bond put?
We believe that central bank policy may have crossed a tipping point where corporations have so much debt, they are – in aggregate – too big to fail. If so, default rates can and should be permanently lower.
Investing for the Future, Not the Past
Whether due to fiscal and monetary policy responses, lower global real yields or more supportive central banks, today’s fixed income environment is fundamentally, technically and structurally different than in the wake of past financial crises. While neither the income nor the diversity offered by bonds may be as high as they used to be, they still offer both in an environment of stretched equity valuations. And, precisely because the current environment is different, we believe bond investing continues to offer opportunities for active management to generate risk-adjusted returns above a benchmark.
1Source: Refinitiv Datastream, West Texas Intermediate Oil Price, LME Copper Grade A Cash US$ per metric tonne, figures as at 20 July 2021
2Source: JPMorgan, 2021 Mid-year High yield Bond and Leveraged Loan Outlook, 28 June 2021
3The term Greenspan Put is a reference to policies put in place by Federal Reserve Chair Alan Greenspan to help halt excessive stock market declines. It is derived from a put option, which is a kind of product sold in the options market that allows an investor to sell a security at a pre-agreed price. A put option can be used to protect its holder from a fall in a securities value, because they have the right to sell it at the pre-agreed value, regardless how low its price may fall.
Diversification: A way of spreading risk by mixing different types of assets/asset classes in a portfolio. It is based on the assumption that the prices of the different assets will behave differently in a given scenario. Assets with low correlation should provide the most diversification.
Consumer Price Inflation: The rate at which the price of a basket of goods and service commonly used by consumers are rising in an economy.