Corporate credit is a market where we believe investors should be selectiveand exercise caution as the global economy reaches the later stages of along expansion. Within the broader credit sector, however, we find pocketsof value – particularly among short-dated (one- to three-year maturity)U.S. investment grade corporate bonds, where technical factors havecombined with fundamental strength this year to create attractively pricedopportunities.
One reason we see value now is the relative underperformance. U.S. IG corporate bonds overall have underperformed both high yield bondsand equities year-to-date on a beta-adjusted basis (as of 30 June 2018, asproxied by the Bloomberg Barclays U.S. Aggregate Credit Average OAS(Option-Adjusted Spread) Index, the Bloomberg Barclays U.S. Corporate HighYield Average OAS Index and the S&P 500, respectively).
Further, relative to full maturity IG credit, short-dated IG credit spreadsover like-maturity U.S. Treasuries have widened in a similar magnitude asfull maturity credit since the beginning of 2017, while offering a lowerrisk profile and thus underperforming on a beta-adjusted basis (see Figure1).
In addition, the front end (one- to three-year) of the IG credit index hasunderperformed the full IG index from a yield perspective (see Figure 2),primarily due to selling by non-U.S. holders as the costs of currencyhedging have risen. We believe these trends point to an attractive relativevalue for short-dated IG credit today.
Relative valuations appear attractive as well, with average one- tothree-year IG corporate bond yields trading 1.8 percentage points aboveequity dividend yields (the largest gap since 2010). They are also tradingjust 1 percentage point below the full-maturity IG credit index, whichrepresents the flattest credit yield curve since 2010, primarily due to thesignificantly flatter U.S. Treasury yield curve and the underperformance ofshort-dated bonds.
Thus, one- to three-year IG corporates may appeal to investors who areconcerned that the credit yield curve will begin to steepen, but do notwant to give up their exposure to credit with its potential yield overtraditional cash-like investments.
Fundamental improvement among investment grade issuers
What about the health of issuers? Based on the most recent completedearnings round (Q1 2018) as reported by J.P. Morgan, U.S. investment gradecompanies overall continued to strengthen: Year-over-year, EBITDA (earningsbefore interest, taxes, depreciation and amortization) are up 10.7%,revenue has grown 8.3% and capital expenditures are up 4.4%. Despite risinginterest rates, interest coverage is still decent at 10.2x and net leverageis relatively stable at 2.8x, particularly given the rise in equity marketcapitalization (the ratio of current net debt to enterprise value is 27% –see Figure 3). Many U.S. companies have also benefited from the Trumpadministration’s recently enacted tax reform.
While merger-and-acquisition activity has been on the rise, as well asdividends and cash returned to shareholders (up 14.6% year-over-year), theimpact on the fundamentals of IG companies has remained somewhat subduedgiven the overall strength of the U.S. economy and the private sector.
As always, credit research and thoughtful, rigorous analysis of individualissuers and issues are critical. This remains an environment forselectivity in credit.
Supportive supply/demand profile
Year to date in 2018, the average maturity of newly issued investment gradecorporate bonds is around 1.2 years longer than it was last year. This ismainly because companies are taking advantage of the flat yield curve toterm out their debt maturity profiles. Some companies (such as large-captelecoms) have tendered or switched out of their front-end bonds, again dueto the flatness of the yield curve. This dynamic should help ensure thatshort-dated IG corporate issues will remain well-supported. Historically,the supply of short-dated bonds (i.e., those with maturities under fiveyears) has usually been lower than the supply of medium- and long-termbonds combined, and the current supply is significantly more constrainedthan 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 IGbonds. Rising hedging costs could translate into less demand from somenon-U.S. investors, but overall yields – especially at the front end – havebecome more attractive to others due to recent spread underperformance. Itshould be noted that many non-U.S. institutional accounts exclude highyield and crossover bonds from portfolios, so demand is likely to beconcentrated in IG credit.
At current prices, short-dated investment grade corporate bonds offer anattractive risk/reward profile, in our view. They have historically tendedto offer more stable returns and lower volatility than full-maturitycorporate bonds. They tend to be less sensitive to interest rates, apotentially attractive feature in a moderately rising rate environment. Andthey tend to be more resilient in unexpected economic downturns given lowerdefault risk and better earnings potential in the short term versus alonger horizon.
Considering such strong fundamentals and supportive technicals, we see a compelling argument for front-end IG corporates.