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Technical Tailwinds


Technical headwinds from 2020 are turning into credit tailwinds for 2021, creating potential opportunities throughout the U.S. corporate credit market.

Reversal of fortune?

As the pandemic hit, U.S. Treasury yields were driven to fresh all-time lows, the yield curve flattened, money market funds swelled, and credit issuance was a record-shattering ~$2 trillion in 2020.

Credit markets still rallied given extraordinary central bank support and retail buying. But, these factors created some technical headwinds among many traditional investors:

  • Overseas investors saw a dwindling premium, particularly given hedging costs
  • Pension plans became hesitant about increasing their interest rate hedge ratios
  • Insurance investor assets under management (AUM) grew slower than credit market issuance, making it harder for insurance company demand to help absorb the new supply

However, as the economy continues to recover, the yield curve has steepened and so it could be that the technical tide is about to turn.

A steepening curve attracts foreign buyers

International U.S. credit demand tends to correlate with the shape of the U.S. Treasury yield curve, subject to a one-year lag (Figure 1).

Figure 1: Foreign U.S. credit buying has been yield-curve sensitiveForeign U.S. credit buying has been yield-curve sensitive

Source: Bloomberg, January 2021 | Past performance is not indicative of future results.

A flattening curve in 2019 resulted in less foreign demand in 2020. However, for much of 2020 and indeed the last two months, the curve has been re-steepening.

While the Federal Reserve’s (Fed) extraordinary policy has kept front-end yields anchored, long-end yields have been rising – given a light at the end of the pandemic increasingly visible and the prospect of rising Treasury supply to finance the Biden administration’s fiscal stimulus ambitions. This dynamic has led to steepening of the U.S. Treasury curve from 60 basis points (bps) to nearly 200bps.

A steeper U.S. curve tends to attract, in particular, Japanese pension funds and Taiwanese life insurers into longer-dated U.S. credit, with the aim of locking in income and “rolling down” the curve (a steep yield curve can potentially result in capital gains over time. Assuming the curve remains unchanged – and all else being equal – as bonds approach maturity their yields fall, implying their prices will rise).

Hedging conditions have also improved for overseas institutions. Hedge-adjusted U.S. credit yields are near three-year highs for Taiwanese investors (Figure 2).

Figure 2: Taiwanese hedge-adjusted U.S. credit yields are around three-year highsTaiwanese hedge-adjusted U.S. credit yields are around three-year highs

Source: Bloomberg, Barclays Research, December 2020. Currency hedging costs calculated using three-month foreign exchange market (FX) forwards. | Past performance is not indicative of future results.

In Europe, core government bond yields are still in negative territory. U.S. credit can offer Europeans a potential ~80bps yield gain on U.S. credit after hedging (Figure 3).

Figure 3: Hedging costs for European investors are relatively lowHedging costs for European investors are relatively low

Source: Bloomberg, February 2021. Based on the assumption the investors sell euros to buy dollars in the spot market and simultaneously sells dollars in the forward market to buy back euros. | Past performance is not indicative of future results.

Credit curves are also notably steeper in the U.S. than in European counterparts, given greater long-dated issuance (Figure 4).

Figure 4: U.S. credit curves are steeper than Europe

U.S. credit curves are steeper than Europe Source: Bloomberg, Barclays, February 2021. OAS represents the option-adjusted spread. | Past performance is not indicative of future results.

Foreign demand has already materialized in 2021 and has been met with long-dated issuance.

For example, an international chain of convenience stores raised $10.95 billion at the end of January to help fund its acquisition of a gas station business. It started offering the bonds during Asia hours. There were $17 billion of orders placed before the New York open. Elsewhere, a global financial services company sold the first 31-year non-hybrid financial debt tranche of the year in January.

New supply in 2021 is set to fall sharply

Investment grade (IG) supply in 2020 was the highest on record at approximately 2 trillion, and a roughly 50% increase over 2019. However, it increasingly looks like a one-off.

Expectations are for gross issuance to fall approximately 30% in 2021 and net issuance to fall approximately 55% (Figure 5), especially as corporates use outsized cash balances to buy back existing debt.

Figure 5: Gross and net issuance is forecast to fall sharply in 2021

Gross and net issuance is forecast to fall sharply in 2021 

Source: JP Morgan and Dealogic, November 2020 | Past performance is not indicative of future results.

Since the start of October, net issuance has been -$3 billion. Year-to-date in 2021, net supply has been down 49% compared to the previous year.

The 2020 deluge was largely a result of corporates raising defensive liquidity pools to ride out the pandemic-related uncertainty while also locking in even lower yields for longer. Most of this activity is done and dusted, particularly among the largest IG names, which are now largely flush with cash.

For 2021, this leaves the IG market with refinancing needs of only roughly $1 trillion (including only $40 billion in the tech sector – often a source of massive deals). Otherwise, merger and acquisition (M&A) financing will potentially be the sole main driver of further supply this year.

Plenty of cash remains on the sidelines

Following the liquidity crisis of March 2020 there was a rush to the safety of money market funds. Surprisingly, even as markets rallied sharply, this trend has only reversed slightly (Figure 6).

Figure 6: Assets in money market funds Assets in money market funds

Source: Bloomberg, February 2021

This indicates that investors are potentially underinvested on the whole and absent further economic shocks, investors may increasingly start putting cash to work.

Playing 2021's technical tailwinds: BBB-rated securities offer a potential sweet spot

Issuance is potentially likely to be particularly low in the BBB-rated segment in 2021. This is because BBB-rated companies often have the least capacity to engage in leverage-inducing M&A. Many are in fact deleveraging following their own recent M&A transactions.

Large BBB-rated names also tend to be the primary investment destination of Asian institutions, given generous capital treatment. We also expect Asian capital to invest beyond seven-year maturities. We also see value further out the curve, such as 20- to 30-year segment which is also relatively steep.

U.S. dollar emerging market (EM) corporate debt also currently screens attractive to us versus U.S. corporates and we believe it is potentially an attractive investment for investors with cash on the sidelines. The asset class proved itself resilient in 2020, given a corporate deleveraging trend, with many names actively issuing to mitigate refinancing risks. Default rates ended the year with relatively healthy 3.5% default rates (roughly half the rate of U.S. high yield). EM corporate debt also tends to offer higher yields with lower duration (for example, the JP Morgan CEMBI Broad Diversified Core Index has a duration of approximately five years), which can potentially help insulate investors from the risk of a rising rate environment. Lastly, the pandemic showed how divergent economic outcomes can be and an EM allocation, including Asia, can add geographical diversity, which has been able to normalize economic activity faster than the West.

As ever — be selective

We believe that security selection within these medium and longer-dated BBB-rated corporate bonds will be key. The pandemic and changing policy environment have heavily bifurcated the market between “winner” and “loser” sectors.

We look for selective opportunities down the ratings spectrum within “winners” and those we view as best-in-class credits within the “losers” (see Election Winners and Losers for more).

The technical headwinds of 2020 may not have prevented a sharp tightening of credit valuations following the height of the crisis; however, in our view, there remains significant opportunity in targeting the potential beneficiary of 2021’s technical tailwinds.

 

CRN: 2021-0303-8993R

The opinions and views of this commentary are that of Insight Investment and are not necessarily that of Advisors Asset Management.

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.

Past performance is not indicative of future results. It is not possible to invest directly in an index.

Please note: any forecasts or opinions expressed herein are Insight Investment's own as of March 2, 2021 and subject to change without notice. Information herein may contain, include or is based upon forward-looking statements within the meaning of the federal securities laws, specifically Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements include all statements, other than statements of historical fact, that address future activities, events or developments, including without limitation, business or investment strategy or measures to implement strategy, competitive strengths, goals expansion and growth of our business, plans, prospects and references to future or success. You can identify these statements by the fact that they do not relate strictly to historical or current facts. Words such as ‘anticipate,’ ‘estimate,’ ‘expect,’ ‘project,’ ‘intend,’ ‘plan,’ ‘believe,’ and other similar words are intended to identify these forward-looking statements. Forward-looking statements can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Many such factors will be important in determining our actual future results or outcomes. Consequently, no forward-looking statement can be guaranteed. Actual results or outcomes may vary materially. Given these uncertainties, you should not place undue reliance on these forward-looking statements.

A bond rating is a grade typically given by a private independent rating service that indicates a security’s credit quality, which is intended to evaluate a bond issuer’s financial strength, or its ability to pay a bond’s principal and interest in a timely fashion. AAA and AA (high credit quality) and A and BBB (medium credit quality) are considered investment grade. Credit ratings for bonds below these designations (BB, B, CCC, etc.) are considered low credit quality, and are commonly referred to as "junk bonds."


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