By Yoruk Bahceli and Saikat Chatterjee
LONDON (Reuters) – The U.S. Federal Reserve is on a warpath and global equities had their worst start to the year since 2016, but corporate credit, with limited exposure to the hardest-hit tech companies, is showing signs of remarkably resistant.
While US and European corporate bonds – those rated investment grade (IG) as well as riskier ones with junk credit ratings – suffered the biggest losses in January since March 2020, their falls were overshadowed by equities, where a global index lost $7 trillion in market value.
Within the sector, US IG did the worst with a 3% loss, but that was well below the 5% drop in the S&P 500.
Even though US investment grade credit risk premia have reached their highest level in a year, they are at levels similar to those of early February 2020.
Credit may have been boosted less by central bank stimulus; US IG debt holders have returned 9% through 2020-21, while US equities have returned 47%.
Many companies also took advantage of the zero rate period to refinance their debt and raise funds; by last September, US and European corporate debt levels to earnings had returned to pre-pandemic levels.
And as economies recover and corporate profits rise, default risks decline. At the end of 2021, default rates for junk-grade companies — those with credit ratings below BBB-minus — were 1.7%, according to Moody’s.
That’s down from 6.9% in 2020, and even below pre-pandemic levels of around 3.3%.
GRAPH – US Corporate Bond Spreads
But perhaps one of the main reasons for the resilience is what Deutsche Bank calls a “lack of crossover” between equity and corporate debt indices. In other words, their constituents are very different.
The recent equity selloff was most damaging to tech stocks, classified as long-term assets vulnerable to higher interest rates.
Deutsche noted that the top 10 U.S. companies — mostly tech companies — make up 28.5% of the S&P 500 but less than 4% of the IG bond index.
The majority of the main constituents of the IG are non-technological and therefore less vulnerable to movements in the underlying rates.
“If the tech drives a sell-off in the United States, credit will be relatively insulated,” Deutsche told clients, adding that correlations between credit spreads and stock movements have fallen sharply over the past 12 months.
Within credit, the high-yield index, with almost zero tech exposure, outperformed its IG counterpart, noted Flavio Carpenzano, chief investment officer at Capital Group.
Its duration, representing its sensitivity to changes in underlying interest rates, is around 5 years in the US, as high yield debt tends to be shorter term, compared to around 8.5 years in the IG index, according to Refinitiv Datastream.
“It’s an environment where the most interest rate sensitive asset classes are those that are underperforming, meaning tech stocks or (investment grade) credit, while others like credit (high yield) fare better,” he said.
Also in Europe, 20 companies make up almost a third of the STOXX 600 but 7% of the IG index, according to Deutsche Bank.
January’s volatility didn’t stop companies from exploiting the markets; Sales of IG bonds in the United States hit a five-year high, according to data from Refinitiv.
Last month’s jump in inflation-adjusted yields — effectively the real cost of capital — coinciding with the stock market selloff, has begun to tighten financial conditions, according to Goldman Sachs financial conditions indices.
Yet financial conditions, which determine ease of access to finance, remain near their loosest on record and markets still expect US interest rates to peak at just below 2% this cycle – the so-called terminal rate.
GRAPH – Financial conditions are tightening
In fact, corporate borrowing costs in BofA’s US IG index may rise another 80 basis points before exceeding the index-weighted coupon, according to Refinitiv Datastream.
In other words, companies can further reduce their interest charges by refinancing their debt.
“As long as terminal rate pricing or the Fed’s dot chart does not significantly exceed 2%, markets will keep a cap on credit and FX volatility,” said John Marley, CEO of forexxtra, a London-based consultancy.
CHART – US IG yield vs coupon
(Reporting by Yoruk Bahceli and Saikat Chatterjee; editing by Sujata Rao and Jason Neely)
Copyright 2022 Thomson Reuters.