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AAM Viewpoints – Corporate Bond Trends


In the 4th quarter (Q4) investors began preparing for the credit cycle to come to an end and concerns mounted related to potential corporate downgrades. Corporate spreads widened during Q4 and presented opportunities for investors in lower investment grade and high yield credits as Q1 2019 was a strong quarter for risk assets. The ICE BofAML US Corporate BBB Index spread tightened by 52 basis points (bps) and BB credits are 140 bps tighter than they finished 2018 (see the Option Adjusted Spread (OAS) changes in the table below). High yield bonds have rallied more so far this year making BBBs look cheap on a relative basis. The lowest investment grade bonds, rated in the BBB range, lagged high grade credits in Q4, but were up 5.57% in Q1 and have annualized 7.91% over the past 10 years.


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Investors willing to accept more risk could look further along the credit risk spectrum to find value. Lower investment grade (BBB) may still offer some opportunities for investors looking for diversification and willing to do their homework. 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. 


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 2016 at 3.18%, primarily due to downgrades of commodity and commodity-related issuers, the fallen angel rate has dropped significantly to 0.23%, which is below the historical average of 0.55%. On the other hand, the global rising star has moved up from 0.19% in the first quarter of 2016 to 0.45% at the end of the fourth quarter 2018 and could be trending back to the historical average of 0.66%. As you can see below, the trend (and 6-month projections) appear to be positive as the number of fallen angels and the number of rising stars are holding steady.


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Corporate Default Rate


The corporate default rate is another important credit market metric. The corporate default rate reflects the health of corporate issuers in aggregate. As the default rates increase, corporate spreads tend to widen while corporate spreads tend to narrow with credit metric improvement. You may recall the July 2016 Default Report from Moody’s showed the global speculative grade default rate ticked up to 4.7% in July and the expectation was 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 the end of 2016.  Fast forward to March 2019 and the corporate default rate is now at the lowest level since 2011. The Moody’s global default rate closed Q1 at 1.9% with predictions that we could be at 1.5% by March 2020. This new prediction is half the 3% projected at the end of 2018 and remains well below the long-term average of 4.2%. Both the current and projected default rates are well below the 14% reached in 2009. Business services and retail sectors had the highest concentration of defaults in the first quarter of 2019. 


 


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Standard & Poor’s Distress Ratio


Another ratio which can be helpful in determining the condition of the corporate bond market is the Standard & Poor’s (S&P) 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 was 7% in March as the ratios decreased for 8 of 19 sectors. In March 2016, according to S&P data, one in four speculative grade securities traded at distressed levels. The overall distress ratio peaked in 2008 and bottomed out around mid-2011.


Despite increased market volatility and political uncertainty in 2018, funding conditions remained accommodative. We continue to see consistent issuance data as companies take advantage of low borrowing costs and foreign demand remains robust. U.S. investment grade corporate bond issuance was $343 billion, a 77% increase from Q4 and flat with Q1 2018.  Even if you believe the long-term trend for interest rates may be higher, “lower for longer” remains the current theme for income investors as the U.S. 10-year Treasury note struggles to break through 2.6%. The total sum of negative yielding debt in bond issues represented in the Bloomberg Barclays Global Aggregate Bond Index finished March at nearly $9.7 trillion which was up 50% from September. 


Although investors should not be relying heavily on ratings agencies when making buy and sell decisions, the information they provide can be useful and should be part of the decision-making process. The trend in fallen angels and rising stars remains encouraging as is the projection for declining defaults over the next 12 months. For those investors that don’t have the risk appetite for lower grade debt, BBB debt appears to offer value and we continue to overweight corporates and underweight Treasuries. Lastly, remember to diversify across asset classes and sectors when searching for income. As concerns of slowing economic growth are on the rise and as we approach the end of this cycle, we believe interest rates may move higher and investors should consider gradually moving up the credit scale while also taking advantage of opportunities when they present themselves.


CRN: 2019-0405-7355R


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 at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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