How corporate credit investors are pricing the future
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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is an FT contributing editor
Financial market data is endlessly fascinating. In describing collective expectations, it holds a mirror to our hopes and fears. At the moment, however, the picture is confused. It’s hard to immediately square what’s going on in corporate bonds with the prospects priced into other markets.
The overarching market story of the past year has been the rise and fall of expectations around central bank interest rates. While speculation over what happens next continues, growth is expected to slow in major economies, if not stall. And, despite persistent strength in jobs and wage data, some leading economic indicators are flashing recessionary signals.
Equity markets, which depict the anticipated and varied futures of thousands of companies, have been upbeat in the face of this. Investor confidence in upcoming rate cuts may have boosted overall valuations. And the rise and rise of the so-called Magnificent Seven tech stocks is also driving the US market higher on the back of hopes over the artificial intelligence boom. But predictions about the impact of AI have created real winners and losers, foretelling an environment littered with the remnants of creative destruction.
Meanwhile, corporate markets tell another story. Corporate bondholders tend to be a sceptical bunch focused on downside risks. The joke that corporate bonds are like equities, just without the upside, contains a germ of truth. Both can lose everything in the event of default. But while stockholder returns are uncapped, the best case for corporate bondholders is timely payment of interest and a return of principal.
As a result, corporate bondholders tend to be more cautious. So it is difficult to immediately reconcile what’s going on in this market with the prospects priced into the other ones. Today’s corporate credit pricing might more typically be associated with the sunlit uplands of buoyant growth and corporate stability than the dark clouds factored into other markets.
In compensation for credit risk and inferior liquidity, corporate bondholders demand higher yields than those on offer from government bonds of comparable term. The quantum of additional yield — the credit spread — tends to increase in anticipation of rockier economic and corporate environments, leading to poor relative returns. Today, spreads are nearing their skimpiest levels in 20 years.
Structurally, diversified corporate bonds tend to overcompensate owners for credit losses. Schroders estimates holders of US investment-grade and high-yield credit need only 0.3 per cent and 2.2 per cent of spread respectively to compensate them for their expected costs over the cycle. Spreads clear these hurdles easily. But they have consistently cleared them for at least the past 25 years (which does explain why it’s hard for investors to bet against corporate bonds over long periods).
Expectations for inflation to recede have delivered a boon to equity and bondholders of late. But inflation itself has been a boon to credit metrics. US debt service ratios are at their strongest for more than 40 years. However, the factors driving improved creditworthiness have recently flipped. As old low-coupon debt is refinanced at progressively greater yields, the rate of change in debt service costs now substantially eclipses fast-fading revenue growth.
Despite this deteriorating outlook, it’s not hard to find asset allocators who are still keen to hold corporate bonds. The valuation measure they first cite, however, is overall yield rather than spread. Compared with the past three decades, corporate yields are substantial, buoyed almost entirely by higher government rates. Investors see, at last, a realistic possibility of locking in total returns that meet their targets.
Theory dictates that investors price corporate bonds so that they get paid for their expectations of credit losses and liquidity cost vis-à-vis government bonds. Practice suggests that they just want to get paid. Although history suggests that this will happen, expectations of supercharged creative destruction and recession-level rate cuts factored into other markets are perhaps too incongruous with today’s meagre credit spreads for them to be sustained.
As well as reflecting our expectations of the future, financial market prices can change it. Tighter spreads made possible by investors’ allocations have reduced the cost of credit. In turn, that has eased financial conditions and stimulated the economy. Paradoxically, this makes it harder for central banks to swiftly cut rates, undermining valuations across markets and ultimately threatening the very returns that investors are so keen to lock in.