Fundamental backdrop remains favourable for Investment grade credits
 

Corporate bonds in the global investment-grade segment have, by and large, made significant gains over the past four months. This is mainly because of the recent decisions taken by the central banks. Overall, the backdrop remains supportive for this asset class.
Marc Herres

An article by

Marc Herres

Fixed Income Portfolio Management

Group leader, Credits of Non-Cyclical Industries

One of the main reasons for the strong recent performance of corporate bonds is the U-turn on monetary policy made by the US central bank (Fed) in January that saw it halt its series of interest-rate rises. Furthermore, the European Central Bank (ECB) has maintained its expansionary monetary policy in view of weak economic data in the eurozone. Credits are also benefiting from the solid fundamental situation in the corporate sector.

Most companies in Europe and the US remain in good shape. Although they have tended to take on more debt in recent years, overall their profits have risen as well. The ratio of net debt to operating income (EBITDA) has largely held steady in Europe, whereas it has increased for US companies, which have been taking advantage of the favourable level of interest rates to buy back their own shares, raise dividends or make acquisitions. US firms are currently engaging in more stock buybacks than their European counterparts, not least because of the tax advantages they enjoy. As borrowed capital is cheaper than equity, they are able to reduce their cost of capital by lowering the equity balance. This also increases the return on equity.

Companies in Europe are generally more reluctant to take on debt and so they have been issuing new bonds in far lower numbers. It is also likely that there have been fewer attractive takeover targets that would have made borrowing worthwhile. Moreover, many European companies still have painful memories of 2008 and 2009, when firms such as BMW and Metro were having to pay coupon rates of around 8 per cent on their bonds.

Liquidity ratio remains high

A key factor used in the valuation of corporate bonds is the liquidity ratio, i.e. the ratio of cash holdings (cash and near-cash) to bonds that are due to mature over the next twelve months. US companies remain well positioned here with an average liquidity ratio of 2.0 despite a comparatively large proportion of them holding only a BBB credit rating. This puts them in the lower range of the investment-grade segment. However, a report by the US rating agency Standard & Poor’s reveals that defaults in the BBB segment (calculated as the number of corporate insolvencies within a period of twelve months), have in the past 40 years always remained below 1 per cent, even in crisis years such as 2008 and 2009.

Default rates are generally at a very low level

Default rates: investment grade vs. speculative grade
Fundamental backdrop remains favourable for investment-grade credits
Source: Standard & Poor’s Annual Global Corporate Default And Rating Transition Study 2018; as at 16 May 2019

The backdrop for corporate bonds remains supportive

Market indicators suggest that investment-grade corporate bonds continue to offer potential, even if future gains are likely to be more modest. The fact that the global central banks have decided to keep interest rates low for a prolonged period is good news. It means that yield levels will remain low for now, which should provide support for the corporate segment.

Although the global economy has weakened somewhat, growth rates are still in positive territory. There are no signs of a recession at present. So the economic cycle that has persisted for almost ten years is likely to continue, even if we are now in a late-cyclical phase. This bodes well for corporate bonds as they are being supported both on the interest-rate front and by growth. For as long as yields on German government bonds hover around the zero per cent mark but economic growth continues on its upward trajectory, investors looking for returns will focus some of their attention on higher-yielding asset classes.

Geopolitics remain a risk factor, as the current escalation of the US-China trade dispute is clearly demonstrating. In Europe, the unresolved issue of Brexit and Italy’s budget policy are still proving problematic. It will therefore be important to continually monitor the market situation and to act quickly if needed.

Neutral assessment of global credits at present

Global corporate bonds are not denominated in euros, which means that in institutional portfolios they generally have to be hedged against currency risk. But because the cost of hedging against the US dollar is so high right now, because of the large interest-rate differential between the two currency areas, the higher yields offered by US dollar paper are being completely neutralised. For this reason, we are currently taking a neutral stance with regard to global credits.

 

Unless otherwise noted, all Information and illustrations are as at 16 May 2019