Investment-Grade Corporate Bonds: Waiting for the Sleeping Giant to Wake
Technicals are creating some opportunity, but market complacency in the face of headwinds is concerning.
Demand continues to outpace new supply in the investment-grade corporate bond sector. Investment from Asia in both the front end and long end remains strong and supportive of spread tightening. Domestic life insurers, which had been absent for the majority of the first half of 2017, have now started buying 20–30 year corporate bonds in an aggressive fashion. There is also significant cash for reinvestment due to premium take-outs. Meanwhile, supply is limited compared to the past couple of years. Record gross issuance volumes are misleading as net issuance is down 12 percent year over year. Merger and acquisition (M&A) activity was only $85 billion in the first half of 2017, which is relatively low compared to prior years. M&A issuance for the year is on track to reach $160 billion, well short of 2015’s $301 billion and 2016’s $263 billion. We expect supply for the remainder of the year will remain fairly limited, which should help spreads tighten further.
Quarterly M&A Issuance Falls Short of 2015–2016 Pace
Low M&A volumes are contributing to limited supply in investment-grade corporate bonds. M&A issuance for 2017 is on track to reach $160 billion, well short of the $301 billion and $263 billion issued in 2015 and 2016, respectively.
Source: S&P LCD, Guggenheim Investments. Data as of 6.30.2017.
The Bloomberg Barclays Investment-Grade Bond index delivered a 2.5 percent total return during the second quarter. Spreads tightened by 9 basis points quarter over quarter and 13 basis points since the beginning of the year, ending June at 109 basis points. The metals and mining industry remains the outperformer for the year, while energy has lost some steam on the back of a stalled recovery in oil prices. All industries gained in the quarter, and lower quality continues to outperform higher quality: BBB corporate bonds have returned 4.3 percent for the year, while AA-rated and A-rated corporates have returned 2.8 percent and 3.5 percent, respectively. As a result, we have seen a significant flattening of the credit curve beyond 2014 levels.
The Credit Curve Has Flattened to 2014 Levels
All industries gained in the quarter, and lower quality continues to outperform higher quality: BBB corporate bonds have returned 4.3 percent for the year, while AA-rated and A-rated corporates have returned 2.8 percent and 3.5 percent, respectively. As a result, we have seen a significant flattening of the credit curve beyond 2014 levels.
Source: Bloomberg Barclays, Guggenheim Investments. Data as of 7.17.2017.
We believe a dramatic backup in spreads is not likely in the near term given the overwhelming technicals in the market, but the high level of complacency is concerning. The Bloomberg Barclays Corporate Aggregate three-month trading range is currently at its tightest in five years. We will look to add risk at better entry points as we enter a period of seasonal weakness and typically higher volatility. We remain cautious on corporate bonds issued by retailers and autos, as both industries continue to see sub-par earnings results. We continue to add higher-quality, longer-dated risk opportunistically when rates oscillate toward the higher end of their recent range.
—Jeffrey Carefoot, CFA, Senior Managing Director; Justin Takata, Director
Important Notices and Disclosures
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