Recent signals indicate that a bottom has been reached in the U.S. corporate credit market.
Yields have stabilized in recent weeks, indicating at least a pause in the relentless drop in prices of corporate bonds. Before spiking again on Friday, June 10, the yield — which moves inversely to prices — on the S&P U.S. Investment Grade Corporate Bond Index had fallen since its peak of 4.22% on May 6.
The apparent stabilization follows a collapse in bond prices that started in November 2021, when the yield on the index was below 2%, driven by the Federal Reserve's rate hiking cycle, which is reducing the attractiveness of the returns on offer from bonds. Some investors suggest that the Fed's rate hikes are now fully baked into the market, and that prices have fallen by enough to present potential buying opportunities.
"Credit markets have experienced a strong week," said Fraser Lundie, head of fixed income at Federated Hermes Ltd. "Inflationary pressures and the strength in the U.S. dollar we’ve seen recently suggest that the Fed’s aggressive policy to curb inflation is already starting to be felt."
Not done yet
Yet volatility is expected to persist, as market sentiment will be driven by central bank messaging as well as by hard data — particularly inflation numbers and macroeconomic indicators. (The consumer price index increased 8.6% from May 2021 to May 2022, the U.S. Bureau of Labor Statistics reported June 10. It was the largest increase since December 1981.)
"The bond market may have reached a bottom with a recession priced into assets, but risks remain without careful selection," said Colin Finlayson, fixed income investment manager at Aegon Asset Management, who noted that both investment grade and riskier high yield corporate bonds have improved on a total-return basis.
"While they could both reprice wider if the slowdown becomes more pronounced, the violent market repricing has opened up more opportunities to capture alpha than we had at our disposal on January 1," Finlayson said.
Companies in good shape
Corporate credit has been more resilient than equities during the recent economic tumult. Much of the rise in yields is a function of the rise in Treasury yields: The spreads between the yield on the S&P investment-grade corporate bond index and Treasurys have only risen to
This is partly because of the strong financial position of big companies. The pace of U.S. corporate bankruptcy filings in 2022 is the slowest in years, according to S&P Global Market Intelligence data. And while by some measures the risk of default is rising, the level is at historical lows.
"Normalizing for black swan events, corporate balance sheets and households are strong, cash-rich and liquid," said Finlayson. "The various implied interest coverage ratios are at multi-year highs."
The median interest coverage ratio — a closely watched debt measure — rose substantially over the course of the pandemic, according to S&P Global Market Intelligence data. This means companies have more assets such as cash relative to their debt liabilities, making it easier to repay debt and reducing the risk of default.
The median ratio for companies rated investment-grade was 8.1 in the fourth quarter of 2021, significantly higher than the 6.1 before COVID-19 reached American shores.
The outlook is less rosy. The interest coverage ratio was down from the recent high of 8.6 in the second quarter of 2021 and business conditions are changing. Rising cost pressures, from supply chain shortages to higher wages, and higher energy prices are eating into margins, while growth in retail sales is being restrained by breakneck inflation.
Long-term headwinds
"We are positioned cautiously and see little reason to change that view yet," said Salman Ahmed, global head of macro and strategic asset allocation at Fidelity International. "Given the longer-term headwinds still in play, including consumer weakness, high inflation and tightening financial conditions, we do not believe it is yet time to become reacquainted with risk."
Yet the increase in yields, offering returns at a time when equities are volatile, is attractive to some.
"We are constructive on credit as a whole based on valuations," Lundie said, noting that spreads have widened "meaningfully," giving investors extra incentives to buy corporate bonds rather than less risky Treasurys.
"We remain cautious as implied volatility remains elevated and inflationary pressures continue to be a key concern," Lundie said.