Regular readers would recall that back in March we felt that Corporate Bonds offered a once in a decade opportunity. Since then, credit markets staged an unprecedented rally both in magnitude and speed, almost as head-spinning as the sell-off earlier in the year. We continue to believe that this will be THE year of corporate credit and expect further gains well into the end of the year.
The initial snap back was fuelled by a confluence of oversold valuations as well as a remarkable policy response that we felt eclipsed that of 2009 Global Financial Crisis. Since then, a number of key developments have transpired, which we believe are enough to propel a brand new credit cycle that would bring along medium to long term positive tailwinds for the asset class as a whole.
It is by now perfectly clear that the trinity of central banks (BoE, ECB, and FED) is aggressively targeting stability in credit markets so as not to hamper the liquidity of the corporate sector. The difference compared to previous central bank intervention is that this is not only confined to corporate bond Quantitative Easing (QE). Governments have extended the reach by also throwing a lifeline to weak borrowers with little or no history of access to credit markets, as well as through regulatory forbearance via the financial services sector that further fuels credit creation.
What we like about the current developments is the resolve by which the crisis has been tackled globally by policymakers and central bankers alike. The cherry on the cake would be the pandemic acting as a catalyst for deeper EU integration – something that has been improbable and divisive to date. A deeper restructuring of the entire economic area would be transformational for risk premiums. The recent Franco-German proposal, followed by the EU resolution to de-facto redistribute wealth across the continent, has all the ingredients to be that fundamental differentiator.
In addition, this is the first time in the past decade where we see a Global shift in the balance of power between creditors and equity holders. After years of unprecedented debt-fuelled dividend pay-outs and share buybacks, the tables may now be turning. Corporate Treasurers are keenly focused on raising as much liquidity as possible to insure their business operations should the markets seize up again, while also cutting returns to shareholders either partially or completely. Issuers are well aware that the return to normality can mean many things for their companies and the economic path remains very uncertain – all concerns we, of course, have too.
Nonetheless, along the way, we have seen a rally in investment grade corporate credit that has quickly eroded at least half, if not more, of the spread tightening potential that we identified in March. However, just as the market was pricing very little in terms of defaults back in January, we believe it is over-estimating these now. There is still a lot of fear, especially in the High Yield market, which we believe presents an attractive opportunity from a total return perspective. To that end, while the upside in A-rated investment grade corporates is not nearly as interesting as it was six weeks ago, we see plenty of opportunities for Cyclicals and what is perceived to be “riskier” debt to outperform from this point.