Viewpoints

Attractive Valuations in Short‑Dated Investment Grade Credit

Amid overall caution on credit, we believe short-dated investment grade corporate bonds offer a compelling risk/reward profile today.

Corporate credit is a market where we believe investors should be selective and exercise caution as the global economy reaches the later stages of a long expansion. Within the broader credit sector, however, we find pockets of value – particularly among short-dated (one- to three-year maturity) U.S. investment grade corporate bonds, where technical factors have combined with fundamental strength this year to create attractively priced opportunities.

One reason we see value now is the relative underperformance. U.S. IG corporate bonds overall have underperformed both high yield bonds and equities year-to-date on a beta-adjusted basis (as of 30 June 2018, as proxied by the Bloomberg Barclays U.S. Aggregate Credit Average OAS (Option-Adjusted Spread) Index, the Bloomberg Barclays U.S. Corporate High Yield Average OAS Index and the S&P 500, respectively).

Further, relative to full maturity IG credit, short-dated IG credit spreads over like-maturity U.S. Treasuries have widened in a similar magnitude as full maturity credit since the beginning of 2017, while offering a lower risk profile and thus underperforming on a beta-adjusted basis (see Figure 1).

Attractive Valuations Short-Dated

In addition, the front end (one- to three-year) of the IG credit index has underperformed the full IG index from a yield perspective (see Figure 2), primarily due to selling by non-U.S. holders as the costs of currency hedging have risen. We believe these trends point to an attractive relative value for short-dated IG credit today.

Relative valuations appear attractive as well, with average one- to three-year IG corporate bond yields trading 1.8 percentage points above equity dividend yields (the largest gap since 2010). They are also trading just 1 percentage point below the full-maturity IG credit index, which represents the flattest credit yield curve since 2010, primarily due to the significantly flatter U.S. Treasury yield curve and the underperformance of short-dated bonds.

Thus, one- to three-year IG corporates may appeal to investors who are concerned that the credit yield curve will begin to steepen, but do not want to give up their exposure to credit with its potential yield over traditional cash-like investments.

Fundamental improvement among investment grade issuers

What about the health of issuers? Based on the most recent completed earnings round (Q1 2018) as reported by J.P. Morgan, U.S. investment grade companies overall continued to strengthen: Year-over-year, EBITDA (earnings before interest, taxes, depreciation and amortization) are up 10.7%, revenue has grown 8.3% and capital expenditures are up 4.4%. Despite rising interest rates, interest coverage is still decent at 10.2x and net leverage is relatively stable at 2.8x, particularly given the rise in equity market capitalization (the ratio of current net debt to enterprise value is 27% – see Figure 3). Many U.S. companies have also benefited from the Trump administration’s recently enacted tax reform.

Attractive Valuations Short-Dated

While merger-and-acquisition activity has been on the rise, as well as dividends and cash returned to shareholders (up 14.6% year-over-year), the impact on the fundamentals of IG companies has remained somewhat subdued given the overall strength of the U.S. economy and the private sector.

As always, credit research and thoughtful, rigorous analysis of individual issuers and issues are critical. This remains an environment for selectivity in credit.

Supportive supply/demand profile

Year to date in 2018, the average maturity of newly issued investment grade corporate bonds is around 1.2 years longer than it was last year. This is mainly because companies are taking advantage of the flat yield curve to term out their debt maturity profiles. Some companies (such as large-cap telecoms) have tendered or switched out of their front-end bonds, again due to the flatness of the yield curve. This dynamic should help ensure that short-dated IG corporate issues will remain well-supported. Historically, the supply of short-dated bonds (i.e., those with maturities under five years) has usually been lower than the supply of medium- and long-term bonds combined, and the current supply is significantly more constrained than in previous years.

We may see supply dwindle further as U.S. investors step into the market, drawn by the elevated yields and attractive valuations of short-term IG bonds. Rising hedging costs could translate into less demand from some non-U.S. investors, but overall yields – especially at the front end – have become more attractive to others due to recent spread underperformance. It should be noted that many non-U.S. institutional accounts exclude high yield and crossover bonds from portfolios, so demand is likely to be concentrated in IG credit.

Key takeaways

At current prices, short-dated investment grade corporate bonds offer an attractive risk/reward profile, in our view. They have historically tended to offer more stable returns and lower volatility than full-maturity corporate bonds. They tend to be less sensitive to interest rates, a potentially attractive feature in a moderately rising rate environment. And they tend to be more resilient in unexpected economic downturns given lower default risk and better earnings potential in the short term versus a longer horizon.

Considering such strong fundamentals and supportive technicals, we see a compelling argument for front-end IG corporates.

The Author

Lillian Lin

Portfolio Manager, Investment Grade Credit

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Disclosures

Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Corporate debt securities are subject to the risk of the issuer’s inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.

The credit quality of a particular security or group of securities does not ensure the stability or safety of the overall portfolio. Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.

This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America L.P. in the United States and throughout the world. ©2018, PIMCO.