Funding Cost Increases Have Begun

November 29, 2018

Source: Bloomberg Source: Bloomberg

As I observed my many reasons to be thankful last week, I thought about how grateful corporate treasurers must be to have experienced the unprecedented low-interest rate environment over the past decade or so. As the Federal Reserve (Fed) continues its tightening, however, how will corporate bond issuers fare with a higher interest rate backdrop? This week’s chart shows the investment-grade (IG) corporate bond index average coupon relative to the average yield-to-worst (YTW) along with the option-adjusted spread (OAS). Since the recession spurred by the financial crisis, rates and funding costs have slowly declined. This trend appears to not only have flattened out, but actually started a reversal. In fact, year-to-date the YTW is up over 100 basis points (bps).

Earlier this year, the average YTW crossed over the average coupon rate in the index for the first time since mid-2008. Keep in mind the 10-year Treasury yield is up about 60 bps year-to-date and remains in the 3% range, still a very low level on a historical basis. Meanwhile, credit spreads have widened 40 bps to the 130 OAS context, slightly below the average for this time period. Note that in the last two instances when the average coupon trended upward and the YTW crossed over, a recession followed within two to three years. 

CreditSights estimates that about $600 billion of IG corporate bonds are to mature each year for the next four years and decline relatively quickly thereafter. Issuers will be faced with increasing funding costs dependent on the extent to which this debt is refinanced. The $600 billion sounds substantial, but given the growth in the corporate market, it now represents only a little over 10% of the index and about half of the annual new-issue supply experienced the last few years. Certainly, some sectors will realize increased costs before others, particularly those that have shorter maturity profiles given their asset base. Autos, for example, have a shorter weighted average bond tenor given the auto loans they make, while utilities have a long-dated tenor with the long-life assets in their portfolio.


Key Takeaway
The average corporate bond coupon hit a recent low in February of this year and has trended higher as the Fed continues its tighter policy. Given the current U.S. economic growth, moderate inflation and robust treasury issuance, it is quite likely that rates will continue to rise and coupons will slowly follow. Corporate credit spreads, while they have widened, appear to have had a relatively muted reaction to the increasing rate environment so far. As the corporate bond YTW recently crossed over the coupon, this current cycle of yields and spreads shows a similar ominous pattern to those in 2000 and 2008 – signaling a reason for caution. Investors should recognize that those issuers faced with elevated near-term maturities in challenging market segments will be the first to feel the weight of increased funding costs and possibly diminished financial flexibility.

Tags: Investment grade corporate bonds | 10-Year Treasury | Federal Reserve

< Go to Chart of the Week

The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice.  The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete.  Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements.  Actual results may differ significantly.  Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.

Investing involves risk, including possible loss of principal.  Past performance is no guarantee of future results.  All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.

High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.

All trademarks are the property of their respective owners. This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission.

Subscribe to Our Publications