The corporate bond market is getting slightly more focus these days from the financial press, although it is poorly covered vis-à-vis the more exciting stock market. I thought it would be interesting to look at the corporate bond market, since it is a large market and – relatively speaking – represents an attractive asset class. The reason it is interesting to pay more attention to this market now is that yields on corporate bonds have been widening since mid-2020, albeit erratically, but have really moved higher since late December 2021, as you can see in the graph below.
In fact, I just read an article over the weekend in the Financial Times entitled “Investors brace for turbulence in the US corporate bond market”. This article (accessible only to FT subscribers I believe) discusses the large increase in purchases of credit default swaps on corporate bonds in January as investors look to hedge against a further sell-off in corporate bonds. This is validation that we might indeed be at an inflection point.
This E-MorningCoffee article provides a background on the corporate bond market, for those readers that are less familiar with this market, and then will discuss the concerns that might be on the horizon, starting by looking at how this market behaved during the pandemic and prior periods of tightening monetary policy. The tone of the corporate bond market is an important barometer of risk and investor sentiment, arguably more influential that what is happening in the equity markets. Because this article is long, I have provided links to the sections below so, should you wish, you can skip over the parts you might already know.
The corporate bond market is often referred to as the “credit market”, which technically includes bank loans and corporate bonds. However, since most loans are not actively traded, are completely illiquid and are not securities, this article will focus only on corporate bonds. Corporate bonds are bonds issued by companies and financial institutions; this excludes bonds issued by the federal, state or local governments, or US agencies. One very important similarity to the equity market is that on an individual issuer basis, a corporate bond is idiosyncratic and needs to be evaluated using fundamental analysis on a company-by-company basis, and this becomes more and more important as you move down the credit continuum.
The size of the USD-denominated corporate bond market was $10 trillion at the end of 3Q2021 according to data from SIMFA (here), and it is stratified between two rather distinct markets based on the level of risk of the corporate bond:
investment grade bonds, or those rated AAA to BBB- (estimated 80%-85% of total market), and
non-investment grade-rated bonds, or those bond issues rated BB+ or lower (estimated 15%-20% of market). Note that non-investment grade rated bonds are often referred to as “high yield bonds” or “junk bonds” and are considered speculative.
Here are a few headline attributes for the investment grade and non-investment grade rated corporate bond segments, including current pricing, so you can begin to get a sense of the US corporate bond market.
There are messages that can be seen as far as risk sentiment by monitoring pricing, including the “direction of travel”, of both the investment grade and high yield segments of the credit markets. The tone of the credit market is important for other risk asset classes, especially equities. The state of the credit market can also influence monetary policy of the Federal Reserve. Even though most of the narrative at the moment seems centred around a “Fed put” with respect to equities, I think the level of equity indices is less important to the Federal Reserve than preserving liquidity in and proper functioning of the credit market. If there really is such a thing as a Fed put, it would first be focused on the credit market, not equities.
I will be focusing mainly on the US Dollar-denominated corporate bond market, which is the largest corporate bond market in the world. As a word of caution, data – including prices on specific bonds and indices – is not as readily available as it is for the equity markets, so I have worked with the information I could obtain. I will provide historical context for the US corporate bond market back to the beginning of 1997, but this is mainly to help you better understand where we stand today as far as credit. Let’s first look at pricing.
Pricing of corporate bonds is expressed as a spread (the “credit spread”) over the yield of the US Treasury of similar maturity. The illustration to the right from a PIMCO article (here) shows both the risk-free (US Treasury) component and the credit spread component for an AA-rated bond, and how both might vary based on the maturity of the bond.
As you can see, credit spreads generally widen as bond maturities lengthen reflecting the longer “at risk” period for investors. This means that companies pay more to issue bonds with longer maturities. Also, credit spreads widen as companies move down the ratings curve from strong investment grade to weak non-investment grade, reflecting the fact that the bonds become riskier as their ratings worsen. In other words, everything else being equal, BBB-rated companies pay less for their debt than BB-rated companies, BB-rated companies pay less for their debt than B-rated companies, and so on. Formal credit ratings on bond issues are normally provided by Moody’s Investor Service and S&P Global. Even so, active fund investors – especially ones focused on high yield bonds – tend to do bottoms-up analysis on each company independent of the ratings provided by these agencies. Nonetheless, credit spreads are very correlated with ratings, which you will see later when I look at the corporate bond spread and yield indices by ratings category.
One other important point for context related to ratings is that the investor bases for investment grade bonds and high yield bonds tend to be fairly segregated, and each of these investor bases demands different things. Since investment grade-rated bonds are generally issued by larger and more creditworthy companies, investors in these bonds tend to demand considerably less in terms of disclosure, on-going reporting requirements and protection in the form of negative and affirmative covenants. High yield investors demand much more, simply because the margin for error as far as operating performance is considerably less than for an investment grade-rated company. Although you might expect there to be a continuum across the entire ratings curve, the reality is that for both pricing and issues like disclosure and covenants, there is a “night and day” difference once a bond moves from Baa3/BBB-, or the weakest investment grade category, to Ba1/BB+, or the strongest non-investment grade category.
Both the rating agencies and investors look at a lot of factors when evaluating the credit worthiness of a corporate bond to determine its credit rating (agencies) and its price (investors). I will briefly touch on two macro factors that are relevant for all corporate bond issues: the economic cycle, and the level of interest rates. Let me explain each of these in a bit more detail.
Economic cycle: As you might surmise, corporate bond investors focus a lot on the ability of a company to meet its debt service, comprised of interest payments and mandatory principal repayments. The main gauge of this metric is the absolute level, strength and resiliency of a company’s operating cash flow. Not unlike equities, the economic cycle is very influential on a company’s trajectory and level of operating profit. The greater the ratio of a company’s cash flow coverage to debt service, the easier a company will be able to navigate through a typical economic cycle from trough to peak. It is companies with strong coverage ratios and resilient cash flows that have the best ratings.
Interest rates: Yields on US Treasuries affect both the price of corporate bonds in the secondary market andthe cost for a company that wishes to issue new bonds. As UST yields increase, yields on corporate bonds in the secondary market also typically increase to reflect the new reality of higher yields. As the yield required by investors to hope corporate bonds increase, prices of the bonds decrease in the secondary market. The converse is true when underlying UST yields are falling – corporate bonds will increase in price to reflect the lower yield requirement of investors.
From the perspective of companies that issue bonds, changes in UST yields do not change the cost of debt service on existing fixed-rate debt since the coupons of corporate bonds are contractually fixed for life. However, changes in UST yields are very important for companies that are considering issuing new bonds, since the pricing of such bonds is set as a spread over the yield of the relevant (similar maturity) UST. Therefore, as UST yields fall and new corporate debt becomes less expensive for companies to issue, they tend to issue much more debt than when UST yields are high (and corporate debt is more expensive). The issuance of new bonds is referred to as the “primary market”.
Other factors affecting corporate debt: In addition to the two major macro factors mentioned above, there are plenty of other idiosyncratic factors that affect corporate debt from the perspective of bond investors, including things like: sector attributes; fundamental attributes (e.g. strategy, competitive landscape, product margins, pricing power, quality of management, shareholders, etc); the regulatory environment; and so on. In addition to the level of interest rates, another thing that is very influential from the perspective of issuers in the overall state of the capital markets. The state of the capital markets is particularly relevant when looking at recessionary periods or exogenous events that cause stress in the broader financial markets. As we experienced at the onset of both the Great Financial Crisis (“GFC”, the 2008-09 recession) and the pandemic, capital markets can seize up and banks can simply stop lending when confidence erodes quickly and dramatically. This can jeopardise the survival of weaker-rated (mainly high yield) companies that rely on regular access to the bank and capital markets to meet their funding needs, including the need to rollover or refinance maturing debt. The primary market tends to grind to a halt quickly in times of financial stress, which is normally when the Federal Reserve steps in to restore confidence. For example, following the Federal Reserve’s unconventional accommodative policies at the onset of both the GFC and the pandemic, new issuance went from nil to record levels even though the cost of debt had spiked to historic highs, because many companies feared their ability to access the debt markets in the future. You can see this clearly in the graph below from Moody’s showing primary volumes for 2018-2022 (projected) for the pre- and post-pandemic periods, noting that 2020 – followed by 2021 – had significantly larger amounts of new issues vis-à-vis pre-pandemic years of 2018 and 2019.
This has been a very simple and streamlined view of the corporate bond market but hopefully should provide enough context to make the rest of this article interesting for you. Since I will be focusing mostly on the pandemic period, let’s turn our minds back to onset of the COVID-19 crisis in February 2020.
In March 2020, financial market conditions were tightening as the severity of COVID-19 was becoming increasingly apparent. To address the effect on the US economy, the US government and the Federal Reserve announced unprecedented amounts of fiscal and monetary stimulus to assist an economy that was in fact about to be voluntarily shut-down. The landmark piece of fiscal legislation was the $2.2 trillion CARES Act, which was approved by Congress and signed into law by then-President Trump on March 27th 2020. Even before this legislation was signed into law, the Federal Reserve had already lowered the over-night borrowing rate to 0% in two stages less than two weeks apart: a 50bps decrease on March 3rd, 2020 followed by a 100bps decrease on March 15th, 2020. The Federal Reserve also implemented a number of other easing provisions, many of which were coordinated with central banks in other countries to ensure that US Dollar flows remained orderly around the world. As the crisis deepened, the Federal Reserve announced on March 23rd (here) that it would re-start its quantitative easing program. However, this program would be broader than the QE program unleashed during the GFC. Rather than just focusing on US government / agency bonds and asset-backed securities, the new programme also allowed the Federal Reserve to purchase investment grade rated corporate bonds in the primary and secondary markets. However, most at risk at the start of the pandemic were non-investment grade rated companies, including those that were downgraded to junk because of the pandemic (e.g. airlines, cruise ship companies, etc). Therefore, the companies that arguably needed support the most were not given market assistance in the first round of Fed QE because they were not rated investment grade. Realising this, the Federal Reserve announced on April 9th 2020 that it would expand the scope of its QE program by (i) including “fallen angels”[1] in its primary corporate bond facility, and (ii) including “fallen angels” and high yield ETFs in its secondary corporate bond facility. These changes meant that recently downgraded-to-junk companies, or fallen angels, would be supported directly by Fed facilities, but not any other high yield companies. Nevertheless, the broader high yield market benefited from the fact that the Fed would be a buyer in the secondary market of high yield ETFs, which hold a very material amount of high yield bond issues across a broad array of issuers.
This rapid-fire series of steps by the US government and the Federal Reserve stabilised markets enabling them to gradually return to a sense of normalcy over the following weeks even as the pandemic-shutdown was occurring. What are the take-aways from the actions by the Federal Reserve? As far as corporate bonds, it turns out that the Fed actually ended up purchasing only $13.7 billion of corporate bonds and ETFs (of a $250 billion facility) as of June 2021 (according to an article in the NYT here), meaning that the words of the Fed were far more important than the action that followed. This is very similar in fact to what ECB President Draghi said in July 2012, stating that that the ECB would be “ready to do whatever it takes” to save the Euro. In both cases, the words of the heads of the central banks were enough to settle markets and restore investor confidence in the respective asset that was in severe distress at the time without having to actually provide very much in the way of tangible support.
It is also interesting to note that the initial recovery in the corporate bond market was not characterised by smooth day-by-day improvement, and that the improvement was not universal across all sectors or companies. For example, oil prices bottomed in April 2020 as global demand plummeted, and oil prices even went negative on one day (April 20th 2020). A number of small to mid-size US oil & gas companies involved in fracking, most high yield credits to begin with, were in deep trouble as the price of oil fell well below their lifting costs. The prices of these companies’ high yield bonds fell sharply as investors exited the sector en masse, and the rating agencies – also seeing the writing on the wall – quickly downgraded many of these issuers to CCC jeopardising their survival. Also, the travel & leisure sector was badly affected by COVID-inspired economic lockdowns and severe restrictions on travel. Although the US airlines got special support from the government, other sectors like cruise ships, theatres & cinemas, restaurants and hotels got very little direct support as far as their bond issues, which also negatively affected high yield spreads in the weakest ratings categories (e.g. B and CCC). Similar to the fracking companies, many of these companies were junk-rated to start with. The fact that the broader high yield indices include a number of oil & gas and leisure/travel-related companies was undoubtedly a drag on the recovery of high yield bonds, especially of the most vulnerable CCC-rated companies. Fortunately, the presence of the Fed as far as a potential buyer of high yield ETFs provided most of these companies with lifelines, meaning that they were able to access the capital markets and issue debt albeit at very high prices, at least buying them time but at a cost.
In retrospect, the lowering of the Federal Funds rate to effectively 0% and the new, larger and more inclusive quantitative easing programme was about as easy of a “buy signal” for corporate bonds – both investment grade and high yield – as one could ask for, although at the time, I am not sure it looked so obvious because of the unknowns as to how the pandemic would play out. This is a very good example of the “Fed put” as far as credit markets, showing that the central bank does in fact “have investors’ backs” in the darkest of times. Although not the subject of this article, there are investors that believe that the government or Fed should not be a saviour for failing companies no matter what the reason, because this encourages investors to take more risk than they ordinarily would without necessarily bearing the consequences should things not work out. This concept – referred to as “moral hazard” – was discussed a lot at the beginning of the pandemic period when relief was flowing at unprecedented levels from the government and the Federal Reserve. If you want to learn more about moral hazard, check out this article in Investopedia.
To understand corporate bond yields and spreads during the pandemic, let’s look back further to see how corporate bond spreads behaved through economic cycles. The graph below shows corporate bond spreads over a 25-year period starting at the beginning of 1997. During this period, there have been three notable recessions which are depicted in the graph below (shaded areas). The graph also breaks down the issues by rating using ICE BofA corporate bond indices, as follows: BBB (investment grade), BB, B and CCC/un-rated (latter three non-investment grade) indices. The data below is from FRED.
There are three things that I take away by studying this graph. First, in the three recessions depicted during this period, credit spreads increased sharply during or leading up to the recession and decreased at the end of the recessionary period as a recovery became increasingly visible. This is not terribly different than the way the prices of stocks behave during a recessionary period. Secondly, spread widening during crisis periods is more severe as you move down the credit spectrum. This makes perfect sense for reasons I discussed earlier – weaker companies have substantially less headroom to navigate during troubled economic times. As a result, the yields of CCC-rated bonds will increase the fastest and the furthest as stress sets in, B-rated bonds the next, and so on. The safest corporate bonds rated BBB or better will be the least volatile but will not escape a repricing. Lastly, you will see some spread widening that occurred in isolated periods between recessions due to specific nuances. For example, the increase in credit spreads in 2012 was related to the collateral effects of the European (peripheral) sovereign debt crisis, which weighed heavily on global fixed income markets. The credit spread widening that occurred in 2014-15 was initially contained to independent oil & gas companies. Oil fell from above $100/bbl in June 2014 to around $30/bbl by early 2016, which severely affected smaller E&P companies, many rated B and CCC. Also during the latter half of this period, the Federal Reserve began tightening monetary policy, which started with the first increase in the Federal Funds rate in December 2015 (from 0%) and the last in December 2018 (to 2.50%). The point to keep in mind is that while credit spreads react to economic cycles generally, they also react to policy changes and to specific economic events in the economy that might not immediately lead to a recession but often reflect unique events. A shift in monetary policy – currently very relevant and underway – is a perfect example of this.
The table below shows the variation in credit spreads by ratings bucket – including minimum and maximum spreads, the average spread and the standard deviation – for the three recessionary periods and over the entire 25 year period for which data is available. In the last column, I have also included data for European high yield bonds (EUR-denominated).
As you can see in this table, the level of spread widening and the volatility (measured by standard deviation) was far more severe during the long 2008-2009 Great Recession than during the government-induced and short pandemic recession in 2Q2020. This is visible across the entire rating complex from BBB to CCC. It is also interesting to note that the European high yield market, which was in its infancy in 2001, suffered badly during the tech-led recession because it was a relatively illiquid market, was still small, and was far over-weighted speculative new-technology telco and media companies. As the European high yield market has matured, it has become substantially more diverse, stable and reliable.
I will now drill down specifically to the pandemic period. The graph below from FRED shows a more recent period for corporate bond spreads, from the period starting at the beginning of 2020 (pre-pandemic) to the present.
As you study this graph, you might not be surprised to learn that corporate spreads peaked on the same day that US stocks bottomed (March 23rd, 2020), then moved tighter on the day the CARES Act was passed and tightened even further when the Federal Reserve announced its expanded corporate bond mandate under its QE programme on April 9th. From early April, spreads on investment grade and mid/high quality high yield bonds (BB and B) continued to gradually tighten until 2H2021, whilst CCC- and un-rated bonds experienced more volatility during their recovery period for reasons that I touched on earlier (specifically related to energy companies (and low oil prices) and to travel & leisure companies). While many oil companies have recovered as oil prices have rebounded, it has generally been a choppier path for the travel & leisure sector because of periodic government restrictions to see off COVID variants that negatively affect these sectors during these periods. Even so, it is fair to say that the corporate bond market has recovered nicely since the pandemic lows.
However, spreads have been bouncing around since mid-2021, mainly attributable to the fact that volatility in the UST market has been increasing. The ICE BofA BBB-rated spread index reached its tightest level on September 27th 2021 (1.09%). Since then, the BBB-index has widened as yields on underlying USTs have increased and the market has become increasingly volatile (because of ongoing “hot” inflation data and Fed commentary). Since the underlying UST yield makes up a larger percentage of the bond yield (because the credit spread is lower) for higher rated (BBB) bonds, investment grade rated bonds are more sensitive to changes in underlying UST yields than non-investment grade rated bonds. In contrast, the ICE BofA High Yield spread index reached its lowest level on December 28th 2021 (3.01%), about three months later than the BBB (investment grade) index touched its lows. If we stratify the broader high yield asset class and drill deeper into the weakest rating category of CCC, it shows that the CCC-index actually experienced its lowest spreads (sub-6%) in the period from late June to mid-July 2021. Since then, even as investment grade index spreads were continuing to tighten along with broader high yield index spreads, spreads for the weakest of the high yield categories had already started to increase. You might say that high yield investors have been signalling their concerns since last summer for the weakest companies, perhaps a defensive tilt as we have seen from time to time over the last few months in equities. A flight to quality within the high yield asset class is not unthinkable at this stage of the recovery, especially as the Fed takes a more hawkish stance. Or perhaps – similar to equity investors in “high flyers” – high yield investors simply realised that pricing for CCC-rated bonds had gotten too tight in the context of the underlying risks.
My concern is more recent though, as spreads have been widening through much of January and early February, and this widening has accelerated. Of course, US equities were also faltering for much of January and remain fragile, so general risk appetite has been waning overall. BBB-spreads widened 13bps in January, reaching 1.34% at the end of the month (vis-à-vis the categories’ low of 1.09% in late September 2021). High yield spreads widened 53bps (USD-denominated) and 36bps (EUR-denominated) in January, as credit weakened throughout the period. Also in January, the yield on the 10-year US Treasury widened 27bps, so corporate bonds in general saw their yields go higher along with spreads widening. Since the end of January, the 10-year US Treasury has rocketed up further by 14bps, closing February 7th 2022 at 1.93%.
I do not believe we are at the onset of a credit crisis. There is no economic data to suggest that a recession is just around the corner. Corporate earnings remain generally solid, and there is no apparent data suggesting that defaults are increasing. However, it is clear that this period of “easy money” in the corporate bond market is over, and this might be enough to spark a repricing in corporate bonds. Similar to equities, solid fundamental analysis will be needed to identify the real corporate bond winners from this point onwards. In addition, UST yields will likely increase further as the Fed undertakes a series of increases in the Federal Funds rate to address stubborn inflation. While such increases might not immediately be negative for the credit quality of corporate bonds, it will certainly be a negative for pricing should intermediate term yields continue to move higher.
As I mentioned earlier, investment grade rated bonds are much more sensitive to changes in UST yields, so I would expect BBB-rated bonds to continue to be most at risk as far as price deterioration. For me, holding investment-grade rated bonds is similar to holding US Treasuries in that both will get hit by higher yields. If corporate bonds are an important component of the overall asset mix in your portfolio, I would probably stay invested in short- to intermediate-maturity (rather than long duration) corporate bonds. High yield bonds arguably have more protection by definition because of their wider credit spreads, but higher UST yields will affect these companies more severely from a credit perspective should UST yields continue to increase, albeit in a delayed fashion. Perhaps for this reason, high yield index investors might wish to focus on the higher end of the credit spectrum, meaning BB and strong B rated bonds.
As much as I would like to view the current credit spread migration as benign, history has shown that this is probably not going to be the case. The direct effect of the Federal Reserve’s current hawkish tilt on corporate bond prices is apparent, but I also believe that this sort of price action has implications for other risk assets including equities. For this reason, investors should keep a close eye on pricing migration in the US corporate bond market as we move forward, since the tone of this important but often overlooked market is a harbinger of what might lie ahead in other risk asset categories like equities.
**** Follow E-MorningCoffee on Twitter, and please like and comment on my posts right here on my blog. You need to be a subscriber, so please sign up. Thanks for your support. ****
[1] “Fallen angels” are companies with debt that is downgraded from investment grade (Baa3/BBB- or higher) to non-investment grade (Ba1/BB+ or lower). There were a number of large companies that became fallen angels at the earliest stages of the pandemic-recession, and these downgrades jeopardised their very existence because it affected their access to primary markets for financing.