- Trends influencing the corporate bond market for the last 15 months extended through the second quarter and appear to be set to continue through at least the next quarter.
- While stimulus-supported economic measures leaned positive, emerging Federal Reserve (Fed) policy considerations and inflation data occasionally muted investor enthusiasm.
- The pace of COVID-19 vaccinations slowed. The strength and breadth of the economy’s recovery is considered to be at least partially dependent on an increasing percentage of the population becoming fully vaccinated.
- The ratio of gross corporate debt to earnings before interest, taxes, depreciation, and amortization (EBITDA) declined for the third consecutive quarter after peaking in 2Q 2020.
- Agency downgrade activity slowed, with fewer fallen angels, on improved business conditions.
- Mergers and acquisitions (M&A) and shareholder enhancement activity continued to normalize.
- Spreads across the investment grade (IG) corporate complex, at post Great Financial Crisis (GFC) tights as the quarter ended, narrowed throughout the quarter, reaching 80 on June 30, tighter by 16 basis points (bps) and 10 bps than at the end of 2020 and 1Q 2021, respectively.
- IG supply in 1H 2021 was elevated relative to historical averages, although lower than 2020. Fund flows were steady.
- Environmental, social and governance (ESG) matters gained greater prominence, including climate-related and net-zero initiatives, employee safety concerns, and supply chain management policy and practices.
The Fed Exits Corporate Bonds as Attention Turns to its Treasury and MBS Holdings
As the global community seeks to emerge from COVID-19-imposed restrictions, much remains fluid. In the U.S., two important trends appear to be firming: 1) The Fed is beginning to consider actions that would reduce or eliminate monetary policy and interest-rate accommodations implemented in 2020, and 2) the pace of COVID-19 vaccinations is slowing, meaning the percentage of the population that is fully vaccinated appears to be leveling short of initial aspirations.
Strengthening of either or both trends in 2H2021 may affect the pace and extent of the economic recovery. The implications of these and other factors may be consequential for the IG corporate bond market but, for now, fundamental and technical factors that guided 1H2021: improving fundamentals, tight credit spreads, low volatility, and elevated supply amidst strong demand, could continue.
At the end of March, we observed that “Limited net supply of IG corporate bonds in a time of sustained demand, should be supportive of risk assets. There is little pressure to force wider spread levels. We remain of the view that IG corporate bonds can benefit under these circumstances.” These expectations for the U.S. IG corporate bond market were borne out in the second quarter.
Looking forward, IG corporate bonds should continue to benefit from stabilizing business and economic conditions at home and higher value relative to competing domestic IG allocations and to foreign corporate bonds. A potential risk to spread performance is a faster than expected tightening of Fed policy, driving a risk-off posture.
In June, the Fed announced plans to gradually sell a portfolio of corporate debt purchased through an emergency lending facility launched last year. Given strong investor demand and an assumption that the Fed could restart the program as needed, the announcement had little effect on the market.
Attention now turns to the Fed’s nearly $7.5 trillion of Treasuries and mortgage-backed securities (MBS). At a mid-June meeting, “Fed officials opened a dialogue about when and how to slow - or taper - those purchases.”1 The Fed also faces a decision on interest-rate policy in light of higher inflation readings.
The Labor Department reported the personal consumption expenditure (PCE) price index, jumped 3.7 percent in April from a year earlier, up from 2.4 percent at the end of March. Excluding food and energy costs the one-year increase at the end of April was 3.1 percent, compared with 1.9 percent in March.2
The Fed attributes the readings to transitory effects. The effects include a low measurement base in 2020, pent-up consumer demand, and supply chain bottlenecks in commodities and product components like semiconductors. April’s numbers, for example, reflected spikes in expenses for airfares and rental cars, items that can be tied to economic reopening.
The Fed also watches the employment rate as part of its mandate to promote maximum employment, stable prices, and moderate long term interest rates. Job openings remained above pre-pandemic levels and exceeded the all-time peak of 7.57 million set in November 2018.3
While vaccinations may encourage consumer and business activities, the pace of vaccinations slowed as the second quarter closed. From April 13 through June 22, the seven-day average number of vaccine doses administered daily declined from 3.38 million to just under 1.05 million.4
Nevertheless, the U.S. economy is rebounding. GDP increased at an annual rate of 6.4 percent in the first quarter of 2021, the U.S. Commerce Department reported. As of June 25, 2021, the Federal Reserve (Fed) Bank of Atlanta’s GDPNow forecasting model estimated second quarter gross domestic product growth at 8.3 percent on an annualized basis, up from the end of the first quarter.
For the quarter, U.S. IG corporate bonds had a total return of 3.5 percent and a positive excess return versus duration-matched Treasuries of 1.12 percent, as measured by the Bloomberg Barclays U.S Corporate Investment Grade Index.
Gross Leverage Falling Across the IG Quality Spectrum
We view credit fundamentals as a modest strength for the IG market. IG median leverage continued to decline from the 3.0x peak tallied in 2Q20, falling to about 2.6x in 1Q21. Median gross leverage could decline to 2.1x by YE21, per Morgan Stanley (See Figure 1). BBB- and A-rated issuers each have cut leverage since the peak in 2Q20. BBB issuers are motivated to focus on debt reduction given higher debt levels relative to cash flow. With operating earnings expected to rise 35 percent year-over-year (Y/Y), leverage should decline further. Yet, shareholder enhancements and M&A, which should increase in 2021, remain a wild card.
Downgrade activity from agencies and fallen angels have slowed. The recovery in credit is reflected by the number of rising stars—companies upgraded from non-IG credit ratings to IG—outpacing the number of fallen angels by seven to two year to date in 2021, according to S&P Global Market Intelligence.5
Morgan Stanley reported that leverage fell on the quarter for all cyclical sectors, except Energy. Defensive sectors like Healthcare, Utilities, Staples, and Communication Services saw leverage increase on the quarter.
Shareholder enhancements through dividends and share buybacks, as well as M&A, which according to analysts’ reports is expected to increase in 2021, introduce elements of uncertainty into predictions for the second half of the year. The Wall Street Journal reported that through May 7, U.S. companies authorized $504 billion of share repurchases, the most during that period in at least 22 years, outpacing the elevated 2018 levels that followed passage of the Tax Cuts and Jobs Act of 2017.
Cash to debt remains high, with the median at 25 percent in 1Q21, up 6 percent compared with 1Q20. High liquidity levels are not unexpected given companies’ historic tendency to raise cash during recession (See Figure 2). Based on the experience of the prior two U.S. recessions, companies may maintain excess cash liquidity for a time, especially if the risk of variants and lockdowns were to rise.
Increased confidence should drive more spending on shareholder enhancements, which may be financed with debt. In fact, year-to-date M&A-related debt issuance already exceeds $100 billion.
While IG Issuance Remains Sturdy, It Is Lower than 2020’s Historically High Levels
We view technicals as a modest strength for the IG market. IG issuance was $453 billion in 2Q. On a 2021 year-to-date basis, gross supply is second only to the 2020 tally. Still, call, tender, and redemption activity is high and net supply was modest in 2Q (See Figure 3).
Fund flows remain steady. IG bond funds received about $85 billion of positive inflows in 2Q. On a year-to-date basis, IG fund inflows in 2021 are about $208 billion. At $133 billion, intermediate funds have seen the bulk of inflows.
The foreign bid for U.S. corporate bonds remains strong. Based on higher yields and still favorable U.S. dollar currency hedging costs. European investors have bought over $100 billion of U.S. IG bonds over the past year.
Spreads Tightened in 2Q and BBB Corporates Outperformed
We view valuations as a modest weakness for the IG corporate market. IG corporate spreads ended the quarter at an average option-adjusted spread of 80bps or 11bps tighter than at March 31. BBB-rated bonds outperformed other IG-rated bonds. Spreads for BBB-rated bonds tightened by an average of 12bps while A-rated bonds were 8bps tighter (See Figure 4).
Both A-rated and BBB-rated IG corporate spread levels are currently comparable to historic tight periods experienced during 1993 to 1997, 2004 to 2006 and 2018 to 2019. Leverage was low and/or improving during the 1993 to 1997 and 2004 to 2006 periods supporting a case for tight spreads. Leverage is expected to improve in 2021.
Several trends highlighted the continued elevation of ESG themes among IG corporate bond issuers and the increasing interest in ESG-based strategies among individual and institutional investors. The trends are gaining force in practices at the corporate level and policy and regulatory initiatives of governments.
In the U.S., the Biden administration has forwarded climate-risk as a central theme in its policy and regulatory actions. At a climate summit convened in Washington D.C. in April, the U.S. pledged to lower its carbon emissions by 50 percent to 52 percent by 2030 from 2005 levels, nearly doubling prior targets. Several other countries participating in the summit increased their commitments as well. You can read a summary of recent climate policy developments stemming from the Summit in our latest ESG Newsletter (2021 Climate Summit Brings Pledges to Combat Climate Risk). In a series of executive orders and policy directives, the White House also has advanced the issues of environmental justice and climate justice. You can read a conversation about these concepts in our ESG Newsletter article Justice Concepts Integrated in Administration’s Environmental and Climate Initiatives.
For decades, equity markets were most closely associated with sustainable and ESG investing, often because shareholder engagement was more commonly associated with equity rather than debt ownership. The trend continues to shift. Data compiled by BloombergNEF and reported in June set issuance in the global sustainable bond market at more than $3 trillion, fueled at least in part by the pandemic-driven demand for ESG funds.
BloombergNEF reported that total sustainable debt issuance was up from $2 trillion just eight months prior. Only $1 trillion was issued as recently as 2018, “nearly 12 years after sustainable debt labeling began,” according to BloombergNEF. This year through May, sustainability bonds grew by 320 percent, green bonds by 142 percent, and sustainability-linked loans by 253 percent, compared to the first five months of 2020. We explored the topic in a post to our website during April (See Sustainable Bond Innovations Spark Issuance, Boost Transparency.)
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