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Financial Industry Insights from Advisors Asset Management
On August 22, 2016
AAM Viewpoints: Corporate Bonds and the Search for Yield
“Lower for Longer” seems to be the theme for income investors with the U.S. 10 year Treasury note near historic low yields and an estimated $11 trillion in negative yielding sovereign debt around the globe.
As investors search for yield however, there may still be opportunities in the corporate bond market. We continue to see strong issuance data as companies take advantage of low borrowing costs and foreign demand remains robust. U.S. high grade corporate bond issuance is on record pace with over $87 billion month to date through August 15, which pushes the total year-to-date issuance to $935 billion, ahead of the record pace for the same period in 2015. While high grade corporate bonds may be considered expensive after tightening 36 basis points (bps) to corresponding Treasury maturities since February 11 and spreads moved below historical averages, investors willing to accept more risk could look further along the credit risk spectrum to find value. We believe lower investment grade (Triple-B) and speculative grade securities may still offer some opportunity for those investors looking for diversification and willing to do their homework. The spread to Treasuries in speculative grade securities has narrowed, but remains near historical levels with wider than average spreads in Energy and Metals & Mining sectors. However, not only is it critical to review individual credits, it is also important to evaluate trends in the corporate bond market such as upgrades/downgrades (transition risk), default rates, and distress ratios. We are starting to see the potential for improvement in these trends 6–12 months out and expect there will be some opportunities for fixed income investors even as the prognosticators call this a bond bubble.Moody’s Investment Grade Transition Risk
Moody’s provides information on transition risk, which reflects credit quality changes for investment grade corporate issuers. The ratings agency categorizes these credits into two groups, fallen angels (credits dropping out of investment grade) and rising stars (credits rising into an investment grade rating from speculative grade). After peaking in the first quarter of this year at 3.18% due to downgrades of commodity and commodity-related issuers, the fallen angel rate has dropped significantly to 0.18% which is below the historical average of 0.58%. At the same time, the global rising star rate has moved up from 0.19% in the first quarter to 0.27% to end the second quarter and we believe could be trending back to the historical average of 0.68%. As you can see below, the trend (and 6 month projections) appears to be improving as the number of fallen angels is dropping while the number of rising stars is increasing. Continued improvement in these numbers could help support demand in the corporate bond markets and reflects improving credit metrics across corporate issuers.
Corporate Default Rate
The corporate default rate is another important credit market metric. The corporate default rate reflects the health of corporate issuers in the aggregate. Generally, as the default rate increases, corporate spreads tend to widen, while spreads tend to narrow with improvement (lower default rates). The July Default Report from Moody’s shows the global speculative grade default rate ticked up from 4.6% in June to 4.7% in July and the expectation is for the global rate to peak at 5.1% in November (see actual and forecast rates below) with the U.S. possibly getting as high as 6.3% by year-end. This is above the long term average of 4.2%, but the projection calls for the global rate to level off at 3.9% in July 2017 with the U.S. default rate near 4.8% in the same period. Both the current and projected default rates are well below the 14% reached in 2009. Energy and Metals & Mining sectors have the highest concentration of defaults this year, but the trend seems to be improving. According to Moody’s, 121 U.S. companies were put on review for downgrade in the first quarter of 2016, the most in 7 years. However, downgrade reviews in the second quarter totaled only 24 which is a five year low.
Moody’s Global Default Rates:
Source: Moody’s Investor Service
Moody’s U.S. Default Rates:
Standard & Poor’s Distress Ratio
A final ratio which can be helpful in determining the condition of corporate bond markets is the distress ratio. The distress ratio is the percentage of outstanding debt with yields of at least 10 percentage points more than similar maturity Treasuries which S&P defines as distressed debt. The number of distressed bonds as a percentage of the overall market has fallen significantly this year. In March, according to Standard & Poor’s (S&P) data, one in four speculative-grade securities traded at distressed levels. The ratio was down to 14.9% in July and has dropped for five consecutive months. We find this to be encouraging because a reduction in the distress ratio implies that companies may not need to raise additional capital to avoid default.
Although we believe investors should not be relying heavily on ratings agencies when making buy and sell decisions, the information they provide can be useful and we believe should be part of the decision making process. We believe the trends in fallen angels and rising stars are encouraging, as is the projection for declining defaults over the next 12 months. Investors with the appropriate risk tolerance may want to consider looking further down the credit spectrum to add limited exposure to sectors that have been under pressure, such as commodity issuers, as these credits could benefit from continued improvement in the trends mentioned above. For those investors that don’t have the risk appetite for lower grade debt, triple-B debt also appears to offer value. Lastly, remember to diversify across asset classes and sectors when searching for income and I suggest reading a recent AAM Viewpoints from JB Golden (The Risky Nature of the “World’s Safest Bond Market”) as it discusses risks in the bond market and ways for investors to potentially position fixed income portfolios.
This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com
CRN 2016-0808-5500 R
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