Tight Valuations and the Overseas Bid for US IG Corporate Credit

November 4, 2021

Source: Bloomberg Source: Bloomberg

Investment-grade (IG) corporate credit has been resilient, trading in a narrow range for the past few months, with the index closing at an option-adjusted spread of 87 at the end of October. The investor search for yield has also contributed to further spread compression, with the basis of the BBB corporate index relative to A-rated corporates at a slim 36 basis points (bps) — a level not seen since the financial crisis of 2007-08.

Corporate spreads remain close to recent tights and only 10 bps from the tightest levels seen since 2000. There are good reasons to be constructive on corporate credit. The subsiding COVID-19-related risks and a strong economy have led to healthy earnings and solid credit metrics — and credit rating upgrades. 

Technicals in the market are likewise supportive, with abundant investor cash balances ready to be put to work, limiting the ability of spreads to widen, even modestly. Overseas investors are also finding value in U.S. corporates. This week’s chart shows the extra yield available in seven- to 10-year U.S. IG corporate bonds relative to those in Europe. Note the extremely low currency hedging costs for European investors. 

As a result, total foreign buying in U.S. corporates has been on a tear. 2021 remains poised to set a new record for foreign purchases of USD credit, with $120 billion of net purchases year-to-date through August. The current annual record stands at $135 billion (2015). Low hedging costs, the higher carry provided by the USD market and the lack of scalable domestic alternatives in many jurisdictions should continue to support foreign flows. 

The Federal Reserve’s quarterly report of corporate bondholders shows non-U.S. investors are the largest holders, composing almost 30%, ahead of insurance companies and mutual funds. This non-U.S. investor weighting is unlikely to decline as the U.S. IG corporate market currently accounts for 13% of the size of the $67 trillion global fixed-income market — but pays 32% of the entire yield (Bank of America).

Slowing growth, stubborn inflation, a further surge in energy prices and labor pressures are some of the risks that could cause spread weakness. Supply chain-related issues are generally reflective of strong demand and not necessarily a negative for credit spreads, as demand will be delayed in most cases rather than reduced. In aggregate, the consumer entered this environment on solid footing and ready to spend, although a prolonged period of elevated inflation could certainly cause them to tap the brakes on spending.

Key Takeaway

While arguments can be made that spreads could remain firm and range-bound in the near term, with companies on solid footing and strong technicals, it is difficult to envision spreads becoming much tighter given the already tight valuations and the low-interest-rate backdrop. As the cycle continues to mature, I expect investors will adjust to a less-supportive macro mix; one that includes slower growth and much less accommodative policy. Assuming this transition is orderly, it could lead to modest spread widening in coming quarters, with sponsorship from yield-based buyers (pensions, insurers, non-U.S. investors) being an important anchor for IG credit if rates were to rise meaningfully.

Tags: IG corporate credit | COVID-19 pandemic | Inflation | Credit spreads | Federal Reserve

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