“Are credit spreads currently too tight relative to the severity of the current downgrade and default cycle?”, JPMorgan wonders, in a note asking whether the market’s enthusiasm for corporate debt might be disconnected from economic reality.
Nobody would blame you if you answered “yes”. Ostensible signs of exuberance are everywhere. On Monday, for example, can maker Ball Corp (which actually does have a decent fundamental story to tell) set a junk deal record, pricing $1.3 billion in 10-year notes at just 2.875%.
Flows into corporate credit funds are nothing short of staggering. Issuance is off the charts. The bottom line: The Fed has engineered a furious rally in credit against what, by many accounts, is the most challenging operating environment for US corporates in modern history.
So, yes, there’s a case to be made that it’s overdone — especially when you consider the prospects for “scarring” in the economy, as bankruptcies multiply and “temporary” job losses become permanent.
Indeed, JPMorgan observes that for the full year, the number of fallen angels is likely to match levels seen in 2001 and 2009 (right pane below).
And yet, as the bank writes, “the number of fallen angels has been surprising to the downside by declining steadily in recent months after peaking in April”. Besides that, there’s a sense in which it wouldn’t matter anyway, because the Fed is supporting fallen angels.
The bank’s Nikolaos Panigirtzoglou goes on to cite previous research which shows that rating reviews are a more timely indicator of credit trends, given that they obviously precede downgrades and, in some cases, defaults. On that score, the picture is relatively sanguine and mirrors the trend in fallen angels.
“Corporate downgrade reviews have been rather benign so far relative to previous credit episodes”, he writes, adding that “they appear to have slowed successively in Q3 versus the previous two quarters”. And, yes, that does include an effort on the bank’s part to adjust for the fact that Q3 is only halfway done.
But perhaps the most compelling reason to believe there’s room to run for a credit rally which some contend is beyond “stretched”, is simply that when compared to government bonds, there’s considerable yield pick-up. In fact, the bank writes, the ratio of corporate bond spreads globally to government bond yields is “still higher than that seen after the Lehman crisis”.
That figure, Panigirtzoglou remarks, shows “how difficult it would be for fixed income investors to avoid corporate bonds over the medium to longer term, even if they do not find a lot of value in credit spreads on an absolute basis”.
You could argue that corporate bonds are now less attractive than equities, given that it doesn’t really matter where you are in the capital structure when the Fed has essentially declared a moratorium on credit events (more here). But Panigirtzoglou says that globally, credit spreads are elevated versus equity yields, thus making it similarly difficult for multi-asset investors to completely eschew an allocation to corporate bonds.
Finally, JPMorgan notes that a “reduced pace of Fed purchases does not appear to have had much impact on overall inflows into corporate bond ETFs”. So, while a slower pace of corporate bond buying from the Fed hasn’t translated into a reduction in the market’s appetite for credit as an asset class, and increase in Fed buying most assuredly would prompt more front-running.
All of this at a time when US corporate earnings just collapsed 35%.
Of course, that actually counted as a “beat” in today’s environment. I suppose that tells you everything you need to know.