Corporate Bond Valuations Reach Unprecedented Heights
The corporate bond market is flashing warning signs, with valuations reaching nosebleed territory not seen in nearly three decades. A surge in investment from pension fund managers and insurers has increased competition for assets, driving prices up and yields down. Despite the risks, many investors remain optimistic, convinced that yields will remain high by historical standards.
The Sanguine Investor
Most money managers don’t see valuations returning to earth anytime soon. They point to the prolonged period of low spreads, citing fiscal deficits that have made some sovereign debt less attractive. “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,” said Christian Hantel, a portfolio manager at Vontobel.
Risks and Rewards
While some investors are alarmed by high valuations, others are drawn to yields that look attractive compared to government debt. They’re less focused on spreads and more concerned with the absolute returns they can generate. “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.”
Trends Supporting Tight Spreads
Several factors are contributing to the tight spreads, including reduced index duration, improving quality, and a more diversified market. BB-rated bonds, which have more in common with blue-chip firms’ debt than highly speculative notes, are close to their highest ever share of global junk indexes. The percentage of BBB bonds in high-grade trackers has also been declining for over two years.
The Cost of Protection
Tighter spreads mean that the cost of protection against defaults 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.
A Shift in Momentum
While fixed income spreads are tight, a significant shift in momentum would be needed 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.
Market Moves
In recent news, a slew of blue-chip firms raised a total of $15.1 billion in the US investment-grade primary debt market, while Apollo Global Management Inc. and other financial heavyweights won a key lawsuit. The Container Store Group Inc. filed for bankruptcy, and IHeartMedia Inc. completed an offer to exchange some of its debt, extending maturities and reducing principal.
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