Crowded corporate credit trading

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good morning. Ethan, I'm here. Rob will be back tomorrow. The Fed meets this week and is expected to do nothing on interest rates. The real challenge will be parsing Chairman Jay Powell's words with obsessive precision for hints about future rate cuts. I'll be listening for signs that the Fed may slow its pace of quantitative tightening soon. Let me know what you see: ethan.wu@ft.com.

We all know the bond is back.

Initially, the risk-on sentiment in corporate credit makes sense. Bond investors are primarily concerned about his two types of risk: credit risk and duration. The toughest environment for corporate bonds is when interest rates are rising, the economy looks unstable, and there is a deadly combination of rising defaults and falling prices (moving inversely to yields). This was the setting for 2022, when global bonds fell by his 31%. In 2024, the prediction is exactly the opposite. A soft landing and lower interest rates should be a boon for bonds, reducing recession risk while providing capital gains. Moderating inflation and less erosion of fixed nominal coupons on bonds also helps.

The market got the message. High-yield spreads over U.S. Treasuries are tight and at levels consistent with boom times.

The same goes for investment grade. As my colleague Harriet Krafelt has reported, strong investor demand is driving a record wave of IG issuance, concentrated primarily among banks and financial institutions. IG spreads are less than 1%.

Given the macroeconomic backdrop, increased investor interest is entirely reasonable. But that gives me pause. High-yield bonds returned an impressive 13.5% in 2023, in part because recession risk was overpriced and investors were well compensated for taking the risk. Not so today. Is business credit too crowded?

To get a gestalt picture, start by researching Bank of America's fund managers. The January update shows investors' overweight positions in bonds are about two standard deviations above the 20-year average (not distinguishing between Treasuries and corporate credit).

However, on a monthly basis, investors are reducing their bond exposure.

Commenting on the latest market outlook, Anne Walsh of Guggenheim Partners argues that HY can be profitable for cautious investors. He argues that the credit market is becoming steadily polarized between companies that will benefit from margin cuts and those whose balance sheets will struggle in the new 2% to 4% yield environment.

The gray bars in the graph below show interest coverage ratios for single-B (mid-junk) borrowers under various interest rate scenarios. The market expects the Fed to cut interest rates from the current 5.5% to 4% by the end of 2024. If that were to happen, the median interest coverage ratio (EBITDA/interest expense) for moderate junk borrowers would rise from 3.1x to 4.3x. X:

That's a big improvement!

It's average though. With so much weak credit and narrow credit spreads, making the wrong choice can significantly reduce your returns. Walsh points to the weakness of smaller companies in the leveraged loan market, with the bottom quartile of issuers having interest coverage (measured by EBITDA) of less than 1x. Still, the appeal of having good credit is clear. Here's Walsh.

A key factor supporting the credit opportunity story is the current attractiveness of all-in credit yields. Over the past 15 years, yields on corporate bonds and bank loans have only reached such high levels in extremely unfavorable market conditions…

while we are watching [rising bifurcation between large and small companies], there are many opportunities for small and medium-sized companies with good fundamentals and healthy balance sheets. In our experience, this cohort often consists of names that are poorly covered by other research analysts. . . Higher spreads and yields for larger borrowers typically compensate for credit and liquidity risks.

Greg Obenshain, head of credit at Verdad Capital, disputes this, arguing in a recent note that high all-in yields can be deceptive “fool's yields.” The graph below shows that. The blue dotted line shows the hypothetical return of his HY bond if he collects the listed yield. But that assumes there are no defaults. In reality, high absolute yields do not guarantee realized returns. The solid blue line shows HY's actual return, which is roughly tied to HY's highest quality rank, the Double B bond yield (solid black line). The gap between the dotted and solid lines shows the default effect.

The conclusion is: “The lower-yielding, higher-quality BB index provides a more accurate estimate of actual returns. We believe it is the best bet for liquid corporate credit. ” If Obenshain is right, Double B's current yield of 6.2% looks reasonably attractive, but it's a far cry from the 2023 bond bountiful year.

Recession or even economic slowdown is the main risk, especially a decline in credit quality. Walsh admits that markets are “underestimating the still elevated recession risks”, and she is not alone in warning against her complacency. So far, growth has been stable and the slowdown has been gradual. But if circumstances change, optimistic valuations mean there is little margin for error.

A book I read often

“In this world, 95 million euros becomes 100 million euros.”

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