By David Absolon, Investment Director at Heartwood Investment Management
Diverging from recent trends, the US investment grade corporate market has underperformed US treasuries year-to-date. The yield spread (the difference in interest rates between the Investment grade corporate bond and the equivalent maturity risk-free rate) is at the widest level for a year and has surpassed levels during the 2013 'taper-tantrum' episode. The Barclays US Credit Index has returned 0.05% year-to-date (ended 18th September, 2015) versus a 2.37% return for the US Treasury 7- 10 year Index.
Notwithstanding well documented concerns in the energy sector, a significant driver of underperformance in the US investment grade corporate bond market has been the abundance of supply this year, largely due to increased merger and acquisition activity, especially in the pharmaceutical and healthcare industries. Record supply was reported in July, totalling $129 billion, in what is typically a seasonally quiet month. Activity moderated in August, but there are $800 billion in US transactions pending this year and early in 2016 [Source: TCW].
Rising M&A indicates increasing leverage among corporate borrowers and that is always a concern for corporate bond investors. According to JP Morgan, gross and net leverage have both been trending higher since 2012 and have hit new highs since 2000. Debt has exceeded EBITDA (earnings before interest, taxes, depreciation and amortisation) for the past three years. Interest rate coverage remains reasonably strong as debt burdens have grown, but the trend IS declining particularly as the advantage of lower coupons diminishes. Interest expense has risen to a ten-year high of $120 billion, although there is some divergence within sectors.
These indicators show a naturally maturing corporate credit cycle. Nevertheless, US corporate health is still relatively strong on a long-term historical basis. Corporate cash balances remain high and overall funding costs for corporate borrowers remain very low. The Federal Reserve's decision to leave rates on hold this month further reinforces the theme of very loose monetary conditions.
What does this mean for corporate bond investors? Compared with the last few years, active credit selection will be a key driver of returns going forward. For example, within our own portfolios, Financials is a theme we have been playing since 2013 for the yield pickup relative to non-financial corporates, as well as the fact that bank balance sheets continue to de-lever. More generally, a maturing corporate credit cycle can create more investment opportunities for active investors, as there is more potential for bond issuers to mis-price.
Outside of the investment grade corporate bond market, the performance of the high yield corporate bond market has been fairly resilient this year, outperforming US investment grade corporate bonds, despite headwinds faced by the energy and metals and mining sectors. Meanwhile, the global speculative default rate remains historically low. Over the last few years, high yield borrowers have taken advantage of low interest rates to refinance and extend maturities to provide a more sustainable financing path. We are continuing to see valuation opportunities in niche areas of this market, such as energy. We believe some of the broad-based sell-off among energy high yield issuers has been indiscriminate and we have greater confidence in the ability of firms to cut capital expenditure and reduce operating expenses.