Uncharted Waters

 


 July 2020

In recent months, investment-grade debt has experienced a ferocious rally. What’s next? 

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Entering 2020, the U.S. markets were coming off a very strong 2019. Capital markets enjoyed the benefits of improving business sentiment, robust consumer demand and expectations for continued economic growth with limited inflation concerns. In particular, the investmentgrade bond universe (represented by the Bloomberg Barclays U.S. Aggregate Bond Index) returned nearly 14% in 2019, ending with a yield-to-worst (YTW) of 2.79% and an option-adjusted spread (OAS) of 90 basis points.

As Covid-19 concerns led to global economic shutdowns, liquidity quickly suffered as investors sold risk assets. By mid-March, the bond index had given back much of the gains from 2019, as yields and spreads widened significantly, resulting in a YTW of 4.07% and an OAS of 324 basis points.

However, the current landscape is dramatically different since the March lows with the S&P 500® index up over 40% and investment-grade debt rebounding an astonishing 14%. Yields are now just above 2%, with an OAS of 139 basis points.

This unprecedented rally, which followed an equally unprecedented selloff, was triggered by immense monetary support via the Federal Reserve (Fed).

The Fed Current

Spread moves have been violent thus far in 2020, with Fed support being the catalyst for reversal
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Even with record low corporate yields, lower government yields suggest corporate debt offers
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The March 23 announcement by the Fed to establish a Primary Market Corporate Credit Facility (PMCCF) and Secondary Market Corporate Credit Facility (SMCCF) fueled the credit rebound. Despite the facilities not making purchases until late in the second quarter and not buying individual corporate bonds until mid-June, investment-grade debt has experienced a ferocious rally. In addition to spreads and yields compressing, companies were able to secure significant liquidity at record-low yields.

 

Table 1: Spread Moves of IG Issuers
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The Wave of Supply

The compression of corporate spreads and yields took place during the most robust period of investment-grade new issuance in market history. Highly rated corporations have been able to issue debt at record pace, with many corporations raising capital multiple times during the quarter. U.S. investment-grade issuance reach $262 billion in May (the second highest month on record) following $297 billion in April (record setting month), resulting in year-to-date investment-grade issuance exceeding 2019’s $1.1 trillion.

 

Chart 2: IG Gross Supply
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In normal economic environments, excess issuance is cause for concern as spreads would likely widen as a reaction to increased leverage. However, debt issuance during this period has been viewed as the ability to access liquidity and means to weather the “Great Shutdown.” It is notable that a significant amount of issuance has been used as a vehicle to target front-end debt in Covid-19-impacted sectors (aircraft leasing, hotels, etc.), thereby creating a rather strong technical specific to the front-end of the credit curve.

Given global sovereign yields, central-bank support (even if just signaling), and preference for stronger companies, investor appetite has been robust enough to meet the elevated issuance. It is now likely most investment-grade companies have amassed enough liquidity to survive the current economic strain. Thus, we expect issuance to slow substantially in the second half of 2020. Most street estimates place total 2020 investment-grade issuance between $1.4 and $1.7 trillion. If accurate, lower issuance should help reduce investmentgrade leverage levels. In addition, less issuance will help buoy further investment-grade spread tightening as the year progresses.

Record Inflows

During the first two weeks of June, U.S. investment-grade bond funds and ETFs set records for inflows of $14.88 billion and $11.46 billion, respectively. While it matters that yields are historically low, it matters more that spreads are a currently attractive at 139 basis points and offer the potential to tighten. The U.S. investment-grade buyer base was constructed largely of foreign investors, along with mutual funds/ETFs, who bought nearly 80% of net supply from 2010-2019 (per BofA Merrill Lynch). European/Asian investors were most concerned with corporate yields after accounting for dollar-hedging costs, which, thanks to reduced federal funds target rate, have collapsed, thereby making U.S. investment-grade more attractive.

 

Chart 2: U.S. IG Appears Attractive to EUR IG on a Hedged Basis
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Chart3: Significant Yield Opportunity for Japanese Investor
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Additionally, mutual fund/ETFs tend to be predominately purchased by retail investors seeking total return, which is supportive of spreads and inversely related to yield levels—further supporting additional purchases of the investmentgrade asset class. According to JP Morgan, the Fed recently increasing its purchase of Treasuries is also supportive of investment-grade flows and is changing the construct of the overall aggregate index.

 

Chart 4: Weighting of High-grade Corporates within the Aggregate Index has increased to 27%
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Interestingly, the increased Fed purchases have reduced the amount of Treasuries held within the Bloomberg Barclays U.S. Aggregate Bond Index and increased the amount of high-grade corporates within the index by 2.8% since March 2020—the highest level since 1981. This is, by default, increasing passive index-benchmark investors’ allocation to high-grade corporates. By JP Morgan’s estimate, this amounts to nearly $150 billion of incremental demand from index-benchmarked mutual funds/ ETFs over the last couple months.

The Government Lifeboat

There is a strong case that can be made for the further advancement of markets given the multi-layers of support currently in place along with those that can be put in place by governments or central banks. Let’s not forget the recently experienced impact that a massively supportive fiscal and monetary policy via stimulus packages and the Fed can create.

Whether an investor philosophically agrees, the U.S. government has proven willing and able to act as a lifeboat via four behemoth stimulus packages, small business support (PPP/grants/loans), tax-friendly actions, and talk of subsequent stimulus provisions. The Fed has acted to stabilize a nearly sinking ship by reducing rates to zero; purchasing corporate bonds/investment-gradeETFs via the Primary and Secondary Market Corporate Credit Facilities (and recently amending these facilities to broaden the scope of eligible bonds to purchase); and verbally committing to keeping rates near zero for the foreseeable future. Assuming tailwinds of fiscal and monetary action blow us in a prevailing positive direction, these actions are immensely supportive of credit spreads and the investment-grade corporate-bond asset-class opportunity going forward.

 

Chart 5: Treasury Rates
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With a significant base of liquidity and support to address the downgrade and default risk of investment-grade, spread compression could be enhanced further. A successful reopening of the economy would be a tidal wave of strength to support further spread compression of corporates. Additionally, the announcement of a Covid-19 vaccine or treatment would greatly amplify the reopening effect (not to mention reduce the tragic loss of life), and there is hope of treatments by year-end or early 2021.

Charting the Course

As for what lies ahead, the market is very similar to the sea as they can both be quite unpredictable. However, there are often markers that can alert us. Rate and spread levels will be affected by a variety of crosscurrents, which will inevitably determine broad total return. A strong economic reopening should reduce spreads, but could result in higher base rates. A worse-than-expected second wave of Covid-19 or flu season in the fall would most likely reduce Treasury yields, resulting in higher credit spreads. However, it is apparent that public and private sectors, as well as global governments and central banks, are banding together during this crisis to develop a vaccine and fully reopen the economy.

It is important to remember that investment-grade companies are rated as such because they are typically substantial companies that possess the ability to pivot and adapt to changing environments; these are corporations that can better weather the storm of uncertainty than their lower-rated counterparts. However, corporate fundamentals remain under pressure as a result of downstream effects of coronavirus impacts. Investmentgrade downgrades were issued at record pace in the first quarter of 2020, and although volume is expected to slow further in the second half of the year, caution should abound.

Additionally, it is our view that accommodative fiscal and monetary policy is here for a significant duration. This is a major factor in support of lower rates and lower spreads. Finally, we believe the economy will emerge resilient from the depths of the worst economic contraction in several generations.

Conclusion

Investment-grade corporate bonds have numerous buoys to help them navigate a challenging sea, including low-interest rates, central-bank support, and fiscal stimulus. As it relates to fundamentals, the prospects of economic strength in two years are much higher than the prospects of economic strength in six months (it’s notable that we have spent the better part of a decade living with the exact opposite expectation). This favors larger corporations as they can access liquidity with reduced-leverage profiles in the event economic growth stays muted longer than expectations. For fixed-income portfolios in need of an anchoring in investment-grade debt, we believe U.S. corporate bonds offer an attractive risk-return profile.

Superseding the realm of investments, it is vitally important the focus remains on reducing the tragic loss of life, suffering, and heartbreak associated with this pandemic. The combined effort and sacrifice of all of us working together are instrumental to finding a cure and pressing on through this challenging time in history. Our sincerest appreciation and deepest gratitude to those frontline workers who place themselves in harm’s way for the betterment of all.

 

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Pacific Asset Management LLC is the sub-adviser for the Pacific Funds Fixed-Income Funds. The views in this commentary are as of July 20, 2020 and are presented for informational purposes only. These views should not be construed as investment advice, an endorsement of any security, mutual fund, sector or index, or to predict performance of any investment. Any forward-looking statements are not guaranteed. All material is compiled from sources believed to be reliable, but accuracy cannot be guaranteed. The opinions expressed herein are subject to change without notice as market and other conditions warrant. Sector names in this commentary are provided by the Funds’ portfolio managers and could be different if provided by a third party.

About Principal Risks: All investing involves risks including the possible loss of the principal amount invested. Corporate bonds are subject to issuer risk in that their value may decline for reasons directly related to the issuer of the security. Corporate bonds are subject to liquidity risk (the risk that an investment may be difficult to purchase, value, and sell particularly during adverse market conditions, because there is a limited market for the investment, or there are restrictions on resale) and credit risk (the risk an issuer may be unable or unwilling to meet its financial obligations, risking default).

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