The rally in the investment-grade market this year has retraced last year’s late correction in a boon for corporates seeking cheap funding, but many investors now say spreads have gone too tight and are not pricing in enough risk.
There is an overwhelming sense that the late 2018 correction was overdone and that spreads had a long way to come back in, according to multiple investors and bankers speaking to IFR.
And they did. Average investment-grade spreads have tightened 35bp since they peaked at 163bp over Treasuries on the second day of trading this year - retracing back to levels last seen in mid-November, according to ICE BAML data.
Although many believe the late-year sell-off was overdone, there is a growing sense of market pessimism that current spread levels cannot last, or certainly that spreads will not tighten any further.
“We’re ready for a bit of a correction given that corporate earnings are not expected to be terribly impressive in 2019,” Mark Alexandridis, chief investment officer for First Principles Capital Management, told IFR.
“Couple that with slightly deteriorating fundamentals, and credit seems to be aggressively priced at these levels.”
Other investors said that current pricing levels represent the most rosy outcome for macro risks such as Brexit, US-China trade relations and the Federal Reserve’s future rate hikes.
The view increasingly is that these events will not be a complete disaster, which sets up a possible surprise in the market, said David Knutson, head of credit research for Schroders.
“Every bit of favourable news is being discounted faster and increases the chances of a big risk-off moment if those expectations aren’t realised,” he said.
Take, for example, the Fed, which has been the main driver of the rally driven by a belief that there will be no interest rate hikes this year and maybe there will be rate cuts in early 2020.
That view is an about-face from a few short months ago when many banks were forecasting quarterly rate hikes in 2019.
The Fed maintains that it could raise rates another one or two times this year, but at this point any hikes would be a shock to the market, Alexandris said.
“The full 180-degree turnaround is a bit [volatile] and the market is giving them the benefit of the doubt, but if they change again their stance, that is when the market would begin questioning the consistency of their monetary policy approach,” said Wolfgang Bauer, manager of the M&G Absolute Return Bond fund.
FOCUS ON FUNDAMENTALS
With Fed policy concerns swept to the sidelines, investors will focus on market fundamentals such as deleveraging in Triple B corporates.
The rally has been supported by the view that Triple B names can and will pull levers to keep their investment-grade ratings, as evidenced by asset sales from General Electric and Kraft Heinz.
Additionally, several companies such as Anheuser-Busch InBev, AT&T and Boston Scientific have issued new debt to push out their maturity walls and ease their near-term debt burdens.
Others, such as Macy’s and Verizon, have been proactive in simply paying down net debt.
“It is a de-risking strategy to diversify across different terms along the curve because it makes the company less sensitive to volatility and funding costs,” Bauer said. “But, of course, the overall leverage is a fundamental metric.
“So just adding more debt by pushing out maturities does not de-risk the company it - has to be a function of both,” Bauer said.
Investors have been happy with that deleveraging story up to this point and there continues to be value in the Triple B space - both in terms of competing asset classes in today’s market, as well as spread pick-up from this time last year.
In mid-March 2018, average high-grade spreads were trading at 109bp over Treasuries - some 20bp tighter than today’s levels - and in the first two months of last year those credits were trading under 100bp over Treasuries, according to ICE BAML data.
With credit spreads tightening from their recent peak, markets are looking for a correction or a reversion to the average. But the problem is, it can be very difficult or even impossible to determine what “normal” is and how fast it will come, said Dave Plecha portfolio manager at Dimensional Fund Advisors.
“I totally understand when people say, ‘rates are low, they probably can’t get much lower and they are more likely to go up’,” he said. “But by how much and when? That’s really hard to pin down.”
