Corporate bonds

Corporate bonds have become more attractive than equities

Compared to other major stock market declines, the widening of high-yield spreads has been fairly subdued

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By David Rosenberg and Brendan Livingstone

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The stock market fell hard, with the S&P 500 falling just under 24% from its highs. The move came as the United Federal Reserve opted for a much more aggressive tightening path, reducing the chances of a “soft landing” – which was wishful thinking at first – being achieved.

However, unlike other major stock market declines, the widening of high yield spreads was rather muted in comparison. Indeed, although high yield spreads have widened by 215 basis points from lows to just over 510 basis points. Based on the stock market decline alone, we would have expected high yield bond spreads to have widened by 365 basis points, due to the traditional relationship between the two asset classes.

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From our perspective, there are a few main reasons why this didn’t happen. First, the entire equity market decline so far has been due to multiple compression rather than deteriorating earnings expectations, and the latter is more significant for bonds given the implications for debt servicing. Second, the “maturity wall” has been pushed back as companies took advantage of the low rates of the past two years and refinanced bonds that were coming due soon.

Third, the quality of high yield has improved—for example, the share of BB-rated credits rose from 35% to 54% in 2000—and we are emerging from a default cycle that wiped out some of the weaker stocks . in the world of high yield. Finally, the energy sector – which is overrepresented in high yield (relative to the stock market) – has moved from a major headwind in recent years to a tailwind.

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That said, while each of these factors may help explain why high yield spreads have not widened as much as might be expected given the stock market slump, we continue to believe that high yield spreads are expected to widen further as recessionary pressures intensify.

Since peaking in early January, the S&P 500 P/E – based on 2022 earnings – has fallen to 16x from 21.8x. This multiple compression of almost six points explains all (and even part) of the decline in the stock market. During this period, earnings expectations for 2022 have fallen from US$220 per share to US$229 per share.

We continue to believe that the consensus overestimates the likely earnings profile, and therefore downward revisions are likely in the coming months and quarters, but this expectation of higher corporate earnings (from investors) is one of the main reasons why high yield spreads have increased. remained relatively tense.

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After all, cash flow is what ultimately matters for debt service. Thus, until we see a significant decline in earnings expectations, default rates will likely be seen as relatively low, suppressing a potential spread widening.

High-yield bond issuers took advantage of the cheap funding available during the pandemic and refinanced their debt at rock-bottom rates, pushing back the maturity profile of their outstanding bonds.

Only 7% of their outstanding debt matures by the end of 2024, and the peak is not reached before 2029. By contrast, at the end of 2008, 18% of their outstanding debt was due within the next three years, according to an analysis by JPMorgan Chase & Co. So even if growth slows sharply, which will weigh on results, having very little debt to refinance in the short term is a positive dynamic for companies. default outlook.

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But bonds are only part of the story. Companies also have loans on their balance sheets, which will need to be refinanced at much higher rates when they come due. This could put pressure on vulnerable companies’ funding, which will weigh on the broader high yield market. Although the high yield market has held up relatively well, we recommend continuing to favor higher quality credits across the spectrum.

The composition of companies issuing high yield bonds has also improved over time. The share of bonds outstanding that are rated BB (the highest tranche in the high-yield market) has fallen from 35% in 2000 to 54%, suggesting that there is a favorable quality bias, which suggests that default probabilities should be reduced. accordingly to reflect superior creditworthiness (compared to the high yield market in the past).

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Additionally, companies that remain in the junk bond market may be less vulnerable to an economic shock compared to past recessionary episodes. After all, we have only just emerged from a significant default cycle – the default rate peaked at 6.3% in October 2020, which knocked out many of the weakest companies in the investment universe at high yield. As a result, the names that remain generally have stronger balance sheets.

Finally, the surge in oil prices over the past two years means that the outlook for energy companies, in terms of forward-looking cash flow, has improved significantly. High yield spreads unsurprisingly reflect this reality. The average option-adjusted spread (OAS) for non-energy high yield currently stands at 522 basis points, compared to 416 basis points for energy high yield. This 106 basis point discount represents a significant change from the past 10 years when energy traded, on average, at a premium of 174 basis points. With a 13% weighting in the high yield market, this change means that the overall high yield market is trading 23 basis points higher than it otherwise would be.

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Each of the above forces has played a role in limiting the degree to which spreads widen, but we believe that the increased likelihood of a recession will eventually win out in the near term. As a result, our base case is for spreads to widen further (likely to 700 bps), meaning investors should favor investment grade (focus on AAA and AA ratings rather than A and BBB ) rather than high yield (hiding in BB on B and CCC). However, if we get a significant widening in spreads, there could be great opportunities for tactical investors as good credits are thrown out with the bathwater.

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The main premise here is that there are various structural factors that have made, and will likely continue to make, corporate credit in general a more attractive (perhaps less unattractive) asset class relative to equities. We expect the outperformance of debt versus equities to continue, but also caution that there is still some spread widening ahead. It may be best to hedge your corporate credit exposure with a handful of Treasuries and bonds.

David Rosenberg is the founder of the independent research firm Rosenberg Research & Associates Inc. Brendan Livingstone is a senior economist and strategist there. You can sign up for a one-month free trial at Rosenberg’s website.


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