Corporate cash piles are shrinking. You’d better believe the stonk market is stonking. US mortgage rates are above 6 per cent. The yield curve is still inverted, and the World Bank is warning about recession.
And yet! If you were looking just at spreads on US investment-grade corporate bonds, it would be difficult to feel alarmed.
ICE BofA’s investment-grade bond index — tracking the debt of high-quality US corporate borrowers — yields 146 basis points more than comparable Treasuries. That’s not far above the 10-year average of 133bp, and is below the 25-year average of 153bp.
To be fair, the 25-year average referenced above includes financial-crisis mayhem, and 2020’s brief-but-violent sell-off could be pushing the 10-year average spread higher.
Even so, investment-grade corporate bond spreads haven’t even approached their 2016 highs above 200bp, as we show in the chart below. Remember, the 2016 cycle of spread widening was caused by a commodity-price collapse that was notably without an actual recession.
So what gives? There are a handful of potential explanations.
We first wanted to consider the question of quality. Maybe the IG index itself contains higher-rated debt than it used to, because the 2020 panic led ratings firms to downgrade the weakest IG companies to junk. We won’t bore you with the full chart, but there hasn’t been much change.
But the pandemic also prompted every single company to race to build up their cash levels. So maybe companies’ overall leverage levels are lower? Not quite, as CreditSights points out. While leverage levels are generally lower than their pre-pandemic peaks, BBB-rated corporate indebtedness is still close to 2016 levels.
More attention is due to leverage for companies rated one tier higher, in the As. Not only are they are almost as indebted as they were before the pandemic, their leverage is almost as high as their lower-rated BBB peers thanks to an unusually steep rise just this year.
You can see that development in the pale blue line in the CreditSights chart below:
In other words, we can rule out the quality explanation: Overall investment-grade borrowers are only a bit more creditworthy than they were before the pandemic, and are arguably less creditworthy than they were during 2016’s non-recessionary sell-off.
Strategists at Bank of America offer a couple of other reasons for the corporate-bond-market strength in notes this week.
The first is that fund managers could be covering customers’ cash withdrawals by selling Treasuries instead of corporate debt, the bank says: “That could explain why IG spreads did not underperform the broader macro market in 2Q despite the outflows,” they write.
Second, the rise in interest rates means that corporate bond prices are trading at new post-GFC lows, with the index around 93 cents on the dollar. The strategists argue that means the market’s spread would be 8bp wider if they were trading at par, which isn’t entirely enough to move the needle for historical comparisons but is interesting nonetheless. They also argue that discounted dollar prices make bonds more attractive for investors, especially with the 5.1-per-cent yield on ICE BofA’s IG index.
Here at Alphaville, we think IG corporate bonds’ relatively sanguine spreads might point to a trend that goes deeper than just market-pricing quirks or fund manager decisions.
It could also have something to do with the fact that, during the last panic in corporate debt markets, the Federal Reserve stepped in to put a lid on borrowing costs for investment-grade companies by buying IG debt and ETFs.
We aren’t big fans of fuzzy “moral hazard” arguments, but it doesn’t seem especially crazy to think that, after those interventions, at least some investors could expect central bankers to step in again if the wheels start coming off of the US corporate bond market.
In the interest of intellectual honesty, however, we should point out that some evidence against this theory can also be found in bond markets.
Remember, the Fed only bought the debt of companies that had investment-grade ratings at the start of the 2020 crisis. So one would expect high-yield bond spreads to be sounding the alarm in comparison to IG. But they are trading around 477bp, below their long-term average of roughly 525, according to ICE data.
And so far this year, spreads of BB-rated bonds have widened at a pace that basically matches the widening of BBB-rated spreads, CreditSights found. That doesn’t quite fit the Fed-saviour narrative, because if the Fed took the exact same steps in another crisis, its support would probably abruptly stop for companies that are rated BB+ or below in calmer credit-market times (like now).
Oddly enough, however, the credit-quality caveats we ruled out for IG bonds do apply more for HY markets. While IG leverage has been creeping higher for years, the HY market’s leverage levels are right in line with history, according to CreditSights:
The HY bond market also has lower duration, or sensitivity to interest rates, as many of our readers already know. On a duration-adjusted basis, the BB-rated bonds do offer fairly attractive yields compared to their BBB-rated peers.
So while there isn’t inarguable evidence that IG corporate bond investors are trading like the Fed has their back, the relative calm those markets should at least raise some questions. And some officials are sure making it sound like the equity market’s Fed put has expired.