During the past month, high-quality US corporate bonds have underperformed equities – but that may be about to change.
While equities have rallied more than 26 per cent per cent since early March, corporate bonds have lagged behind, weighed down by hefty sales of new debt, worries over financials and illiquid trading conditions.
Investment grade-rated companies have sold $377bn in new bonds so far this year, an increase of 88 per cent compared with the same period a year ago, according to Dealogic.
In contrast, there has been very little equity issuance – until this week’s $5bn issue by Goldman Sachs.
Also weighing on corporate bonds has been concern about the debt of financial companies, which represent a large chunk of the investment grade universe.
“Credit is not nearly as cheap to equities when you exclude financials,” says Barry Knapp, US equity strategist at Barclays Capital.
For a credit rally to really take hold, investors would need to believe that the government will protect the debt of large banks, even if more concessions are required down the capital structure, he adds.
Contributing to the stickiness of bond yields has been a lack of trading and thin liquidity provided by the dealer community, says Michael Kastner, portfolio manager at SterlingStamos. “Financials have really weighed down corporates and a sticking point for banks is the outcome of the stress tests.’’
The equity rally during the past five weeks flowed through into high-yield bonds and leveraged loans, which are sectors that often mimic stocks, while investment grade debt lagged behind. Investors are beginning to shift out of equity and into good-quality corporate bonds amid evidence that the economy’s rate of decline is slowing.
While equity bulls seek green shoots of a potential recovery, many in the corporate bond market believe the economy still faces an extended period of weak performance – not an ideal scenario for stocks.
Mark Kiesel, portfolio manager at Pimco, says investors should fade the rally in equities and buy investment grade corporate bonds with yields of 7 of 8 per cent.
“The Fed rate cuts and various government support programmes are starting to take hold and we have passed the maximum point of pain for the economy and the housing sector,” says Mr Kiesel.
“The benefits of policy decisions are starting to play out but the economic recovery will not be strong and that will provide a headwind for stocks,” he adds.
Mr Kastner says SterlingStamos has been a big fan of credit since mid-December and that, in terms of asset allocation, it makes sense to reduce exposure to equities and move into corporate bonds.
“Stocks have snapped back nicely but look as if they will range-trade for a while, whereas with these high bond coupons, you are being paid to wait,’’ says Mr Kastner.
The average corporate bond is yielding 7.62 per cent, according to a Merrill Lynch index.
The dividend yield for the S&P 500 stands at 3.36 per cent and many high-profile companies, led by General Electric have recently slashed their dividend pay-outs in order to preserve capital.
This means that, if the worst is past for the economy but the likelihood of a sharp recovery in activity is slight, clipping a bond coupon is better than owning stocks.
Andrew Milligan, head of global strategy at Standard Life Investments, says it is advising clients to buy good-quality bonds with attractive yields but are cautioning that volatility will not cease.
“The credit market has been saying for a while that there is an immense amount of pain facing equities,” says Mr Milligan. “The world is improving but the recovery process is slower than what the market thinks.”
Bears also warn that credit is a leading – rather than a lagging – indicator of where financial markets are heading.
“In the last few years when equity has become this overbought relative to credit at the broad market level, we have seen equity correct down considerably more than credit [correct] up,” says Tim Backshall, chief strategist at Credit Derivatives Research.
Plenty of investors remain on the sidelines and the big question is which way this pool of money will leap in the coming months.
The efforts of central banks in reducing rates close to zero per cent means that holding large cash positions provides little return.
Mr Kastner says the risk tolerance of investors remains low and, for now, the two-year Treasury yield is considered a long-dated Treasury bill.
The yield on the two-year note remains below 1 per cent and is little changed from where it began the year, at about 0.8 per cent.
In such an environment where risk remains a four- letter word for many investors, the attractive yields on corporate bonds require close attention.
“If people take investment-grade corporates as a single universe, they are getting a somewhat misleading view of the yields available,” says Dan Fuss, vice-chairman at Loomis Sayles.
Mr Fuss says companies with triple-B level ratings are paying yields of 11 to 13 per cent.
These high yields at the low end of the investment grade credit spectrum are skewing the averages because bonds with higher ratings are no longer dirt cheap, he says.
At more than 500bp, risk premiums for corporate bonds appear wide but the levels must be considered against a backdrop of historically low yields on underlying Treasury bonds, he adds.
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