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The Federal Reserve’s stimulus programs continue to provide support to corporate credit markets amid historically low treasury rates with short-term corporate bonds poised to potentially outperform in the near term. Corporate profits are set to see a rebound in the beginning of 2021 as a vaccine for COVID-19 is in high demand and a return to normalcy is likely. That said, debt remains cheap to service as interest rates are expected to remain low which are both influential in the recent expansion in corporate credit.
As yield becomes increasingly difficult to find in fixed income markets how can an investor take advantage of the growing corporate credit environment, low debt service rates, and a lower exposure to interest rate risk as rates are expected to be volatile in the near future? To answer this question, short duration corporate debt with rules based fundamental metrics and behavioral analysis.
Short-duration bonds are sheltered from excessive interest rate risks and are largely compensated for liquidity risk and its correlation to specific systematic and market related risks. Historically, as an asset class, short-term investment grade corporates have a lower risk of default than longer-term issues during periods of volatility. Short duration’s drag to par insulate principle losses even though spreads widen to meet immediate liquidity needs. Furthermore, the Federal Reserve’s corporate bond purchasing programs and lending initiatives have shielded refinancing and default risks in the short term supporting an already historically lower default asset class. To further the case, short-term corporate bonds are being attractively compensated, in terms of yield, for their exposure (though minimal) to interest rate volatility, credit volatility, and systematic uncertainties.
When comparing yield seeking investment grade corporates investors may ask the question, why not traditional high yield debt? The answer is simple, the asset class’s risk-adjusted returns are uncertain at best as the extent of the current economic dislocation and ongoing COVID-19 economic stresses are unknown and may have lingering economic effects on unforeseen sectors. These looming unknowns paint “caution” on the high-yield space as default risk and systematic risk can be profound or null. Furthermore, with Treasury rates at historically low levels even higher quality corporate bonds yielding around 2% seem an attractive alternative, which is illustrated by the robust demand for these assets.
To take this one step further, just relying on the credit rating agencies for investment grade quality bonds are inconsistent as they are all “pay-to-play” platforms (as illustrated below). This means that companies pay these agencies to rate their bonds, potentially resulting in unknown conflicts of interest that could damage the integrity of the credit rating. Therefore, the lack of change from Congressional oversight and accountability is worrisome.
However, a way to combat this inconsistency is focusing on specific fundamental, thematic, and company specific indicators. Internal research shows that companies with insider buying experience statistically lower default and bankruptcy rates on the intuition that corporate insiders would not take an equity stake in their own company if they were in jeopardy of bankruptcy. This coupled with traditional company specific credit fundamentals such as cash from operations, debt to EBITDA, current assets to current liabilities, debt service ratios, lines of credit, covenants to revolving credit facilities, etc. relative to their peers are essential to the “real” investment grade quality of bonds. Finding misrepresented (thus higher yielding) bonds with fortress balance sheets give investors an advantage to be exposed to investment grade quality bonds that have an attractive yield due to the market’s inaccurate perception, thus, optimizing both investment grade quality and satisfying the pursuit of yield. Furthermore, this approach also minimizes the exposure to potential “fallen angels” (investment grade to speculative bonds) which could hurt overall risk adjusted returns. Potential “fallen angels” have been a popular topic lately as the amount of BBB- rated borrowers with a negative outlook has reached the highest levels since the first quarter of 2009.
All in all, opportunities for yield capture are still available despite down trending Federal Fund’s target price, overall (debt to global output) increasing leverage, and the need for governments to keep rates low to sustain the massive fiscal expansion. Taking advantage of credit rating agencies’ inaccuracies supported by a rules-based credit analysis and fundamental behavioral analysis are the keys to finding value in the bond market during the current environment. Looking forward yields may continue to be low as government spending increases, global debt continues to increase relative to GDP, and global aggregate bonds yields continue to decrease. However, based on a strategic approach investor seeking yield still have attractive opportunities.
