Macro Markets Podcast Episode 49: Evaluating Investment Grade Corporates (and Listener Mail)
Justin Takata, Head of our Investment Grade Corporate Credit Sector Team, and Investment Strategist Maria Giraldo discuss the investment grade corporate bond market.
This transcript is computer-generated and may contain inaccuracies.
Jay Diamond: Hi, everybody, and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, Head of Thought Leadership for Guggenheim Investments, and I'll be hosting today. We are recording this episode on Leap Day, Thursday, February 29th, 2024. Before we begin, I want to thank our listeners for tuning in and remind you that if you have any questions for a podcast guest, please email us at macromarkets@guggenheiminvestments.com. And at the end of today's podcast, I'll be reading a question from one of our listeners For Karthik Narayanan, our head of Structured Credit. He was a guest on our last episode, and I'll read his answer. I also want to mention some good news that hit the tape today. Guggenheim Investments was named by Barron's magazine as number one out of 49 fund families in the taxable bond category for 2023 based on manager performance. It's the second time in four years in which we've come in number one in this highly competitive ranking. So, congrats to all of our investment professionals responsible for our fund performance, including our guests today, and thanks to all of our investors for your trust in us. Okay, let's get right into it. Our topic today is the investment-grade corporate bond sector. After Treasurys and Agencies, investment-grade is the largest of the fixed income universe and a mainstay of fixed income investing. There's been a lot of activity in the sector recently. And here to tell us all about it is Justin Takata, Head of our Investment-Grade Sector Team, and Maria Giraldo, strategist on our Macroeconomic and Investment Research Group. Welcome back, Justin and Maria, and thanks for taking the time to chat with us today.
Justin Takata: Thanks, Jay. Good to be here.
Maria Giraldo: Yeah, I'm excited to be here, Jay. What a perfect timing to talk about investment-grade bonds given our Barron's ranking.
Jay Diamond: Exactly. Well, to dive into it, let's discuss some of the major themes that are in the investment-grade market today, which we're going to be calling the IG market throughout, so people get used to that. But Justin, what are some of the big themes that you are seeing?
Justin Takata: If we kind of divide the investment-grade bond market into at least two kind of topics, one would be the primary issuance, which is where corporate bond issuers raise debt and capital for the companies, and we as investors buy that debt. And of course, then what we do or what we're seeing in the secondary market with trading flows and demand there. On the primary side, there's been a very robust start to the year for primary issuance, which I think is very topical. But on the other side of that, demand for the debt issuance and in the secondary market has been extremely robust as well. And so, we can talk about further in this podcast about the dynamics of how that affects the market for supply and demand. We can talk about fund flows as well and general flows in the market. And I think it's pretty interesting what we've seen so far this year, whether it be mutual funds, or ETFs, or just regular secondary cash trading. I think that's really started to influence where we start seeing credit curves, whether they're flatter or steeper. And so, I think that's been extremely topical as well. I think finally, if we take a step back where we are historically in both spreads and yields is extremely important for some investors to kind of take notice of. And I think we can highlight that in some examples and put some numbers to that.
Jay Diamond: Great. Thanks, Justin. Now, Maria, what are some of the big things that you're watching develop?
Maria Giraldo: Well, as part of our macro group, I would say we were focused on much more sort of higher-level topics, like looking at the balance between an economy that for us looks like it's still signaling these end of cycle indicators that would normally suggest that we're heading into a recession. But then we're balancing that against what we're seeing in corporate credit fundamentals, which in aggregate looks actually pretty good. Then separately, what's happening with credit flow and bank lending. By design, the Fed's tightening cycle was meant to slow the flow of credit, which to some extent happened last year, but now we're seeing signs that the worst is behind us. So, what are the implications for that to the economy? We're keeping an eye on emerging bifurcations in the data that suggests that even if we do avoid a recession, that's not going to be the story for everyone. And then finally, what does this all mean for the Fed easing cycle? The market is highly anticipating the start of rate cuts, and so we've been thinking a lot about what the implication is for interest rates over multiple horizons, whether we're looking at now to the end of the year, or next two years, or even the next decade.
Jay Diamond: Justin, let's dive a little deeper. What are you seeing right now in supply and demand for investment-grade corporate credit?
Justin Takata: When we think about supply in primary issuance, it's been absolutely a phenomenal start to the year. On a gross basis, issuance is up about 30 percent year-over-year. A lot of that's attributed to a decent amount of pent-up M&A financing that was either brought over from last year or even pulled forward from this year. And then we're also seeing just outright issuance pulled forward given how tight spreads are. And just to kind of frame that out as we've rallied so far this year and earlier in the year, both in rates and in spreads, that really sometimes gets issuers off the bench and encouraged to issue debt. That being said, I think, a lot of that debt that gets issued is more on the 10-year and shorter maturities. Those issuers really believe in this lower rate story further out this year with rate cuts which Maria will discuss. So, they're sticking to shorter maturities instead of locking in that longer 30-year type fixed coupons, right? So that's definitely making them a little bit more reticent as of now to issue further out the curve and lock in those higher rates within their capital structure. I also think it's the robustness in the primary supply so far this quarter, even though it has been up 30 percent year-over-year, we really expect it to be reasonably flat by the end of the year versus 2023. So just to level set there, we had around $1.2 trillion last year and we're expecting the same amount this year. Now, these numbers I'm giving you are really based on gross issuance, but net issuance that takes into account maturities, bonds that are maturing and coming due and/or liability management, which is tenders, right, where companies that try to retire their debt early at what are attractive levels to them. Now when we take into account these types of actions, maturities and liability management, we see issuance actually being down 20 percent on a net basis year-over-year. So, what does that all mean for demand? So just at a very high level, if you have 20 percent net less bonds to purchase and your demand stays very constant year-over-year. You naturally think that spreads could tighten or it's at least going to create a very supportive environment for credit spreads. And that's what we're seeing so far this year, as I think everyone sees these estimates, and again, although robust supply starting early in the quarter, taking this opportunity to add that exposure. And so, what does that demand look like? Right. And so, we're really getting demand from every kind of facet or investor base you really can within the IG market historically. So first of all, we can talk about passive demand. When you think about passive demand, think about mutual funds and index funds. They've been extremely active in the secondary markets and they're buying outright cash bonds, and hedge funds and macro funds are also involved. In these strategies, they’re really using ETFs, exchange traded funds, and other derivatives to express their view on the market. And I would say that there's, definitely a bifurcation on whether they're bullish or bearish, but either way, at the end of the day, I think it's more important that they're using ETFs. The demand also from traditional buyers such as insurance companies and pension funds has also been in that long duration cohort. The demand from both passive and active investors has been extremely strong, and that's really supported the spread performance we've seen so far this quarter. And that's coupled with what arguably will be negative net supply by the time we get to the end of the year.
Jay Diamond: Just to follow up, what are you seeing in flows right now?
Justin Takata: The interesting thing is, even to go back to call it mid to late October, in the middle of the fourth quarter last year, when we started to see very steady inflows into investment-grade funds. And so as of last week, we've had 17 consecutive weeks of inflows into IG funds, right, really averaging about $6 billion per week. And that's going to create and support a really strong technical for spreads. ETFs have become a bit more tactically driven, whereas I think mutual funds are really investing that money as they get inflows, really looking for cash bonds, or potentially some type of cash bond substitute while they wait for, say, primary issuance or the right opportunity to buy cash bonds. But that mutual fund flow has been extremely consistent and will be directed into those investment-grade corporates, which again is going to be very supportive of credit spreads.
Jay Diamond: Maria, Justin's given us a full lowdown on the technical side of the market. What are you seeing on the fundamental side in corporate credit risk?
Maria Giraldo: We're obviously seeing so much demand, and Justin mentioned this a few times too, about how tight credit spreads are. We monitor the spread levels on a historical basis, turn them into percentiles, and in IG, for example, spreads have only been tighter, something like 20 to 25 percent of the time, depending on how far back you go. We typically take this data back to 1994. So that's a perfect question, right? Like, well, what's the view on credit risk given how tight spreads are? Are the technicals kind of hiding some sort of imbalance on the fundamental side? And I would say probably the answer is no. At a very high level, we're not seeing major imbalances in corporate credit fundamentals, and that's to say, for example, specifically, we don't see a single sector where there's excessive leverage and that is highly entrenched within consumer fundamentals for it to present kind of a big macro risk. If anything, some of the telltale signs that we would normally see at the end of cycles that have led into severe recessions, they're not there. Normally, there's a speculative phase of a bull market, for example, where earnings are weak and borrowers are just continuing to borrow, taking on disproportionate amounts of debt. That hasn't happened. Leverage has been stable and there's not a lot of demand for debt. A lot of the Fed surveys show that it's not just because banks have pulled back on lending, it's because there's no demand for it right now given where rates are. C-Suites have approached this environment pretty conservatively. That's actually not something that would have happened to historically. Interest expense, I think is an even more interesting story because interest rates have been going up. You would expect that for the economy as a whole, for nonfinancial corporates, their interest expense should be going up. But actually, interest income is rising more than interest expense. So that's happening because there's a lot of deposits still in the system, a lot of cash that large companies are sitting on, and they're earning attractive yields. So, in the aggregate, actually net interest expense is falling. So that means that the ratio of cash flow to interest expense, at a very aggregate level, is at the best level we've seen since the 1960s. But there's a big but in this data, and that is that it's aggregate data from the Fed's financial accounts, and some of our listeners might know this as the flow of funds. So, it adds up everything. It sort of puts together highly levered companies that maybe don't have as much cash along with the Apples and Microsofts, and the just very large tech companies that have a lot of cash holdings. So, under the surface, we need to keep in mind that there is a lot of dispersion. We looked at specifically the S&P 500, the large caps, versus the S&P 600, the small caps, and we found that on a year-over-year basis, we are seeing interest expense increasing at a much higher rate for the smaller companies. Interest expense as a percentage of the cash flow for the smallest companies has increased from something in the tune of about 15 percent to 28 percent. So, it is eating up cash flows in the corporate credit market. It’s just you need to know where to look. You need to know where the sensitivities and vulnerabilities are and understand that we're looking at a much more fragmented credit landscape than we were last year.
Jay Diamond: Justin, you mentioned earlier that you've been watching developments in the credit curves. So, explain a little bit more about what that means and what you are seeing.
Justin Takata: One of the bigger themes that we have seen, right, is what's going on in the 10s-30s credit curve. They're really near the recent flat levels historically. And when I say flat, that's really just really meaning that the incremental spread an investor received from investing from 30 years versus 10 years, and that's decreased materially, right. So, the two major factors really are, one from the demand side and one from the supply side. I think on the demand side, you have a lot of long liability investors, that's pension funds and insurance funds typically, that require long duration assets to match their liabilities. But I'd say I think the second factor, which is just as important and impactful, is from the supply side, and that's where we've seen a dearth of 30-year issuance. And really that aforementioned hesitancy from companies to issue longer dated maturity debt at these elevated levels has really caused that reduction in 30-year supply. So, you kind of got two things working towards each other here. Strong demand, not a lot of supply, and so, it's brought those credit curves flatter in the 10s-30s part of the curve. But I do think another interesting theme that's going on in the curve is a little bit shorter, and it's been kind of I think, less impactful so far--but it's gaining momentum--is that traditional IG investors like asset managers, mutual funds, index funds, they are starting to focus a little bit more in buying that 7-to-10-year maturity cohort. And one, because of what we just talked about, the flatness in that 10-30s curve, if 30s are getting a little bit rich, then arguably 10s could potentially look attractive. If you extrapolate everyone's belief that not only Treasury rates are going to go lower, but really more importantly, you're going to start to see the Treasury yield curve steepen or uninvert, that's going to bring back that nice roll down effect that we typically see in investment-grade corporates. So, positioning yourself for that 7-to 10-year maturity bucket starts to align your views on what's going on in the yield curve. So those are two things I think that are pretty thematic within credit curves.
Jay Diamond: Just as a follow up, Justin, do you do you think this trend is going to continue?
Justin Takata: There's a real push and pull right now in the corporate market, and I'd say that when I look at hedge funds and macro funds, they're definitely selling 30-year risk overall, right, given that flatness of the credit curve. The liability driven investors are still buying those long duration assets, again, there's not a lot of long duration assets around there, and it's really more part of their mandate and they just really aren't available. So right now, there's a very healthy market flow, if you will, a balance of buyers and sellers of that 30-year risk. And I think overall, though, that's going to keep credit curves flat in the long end. As for the short end, until we really start to see U.S. Treasury front-end yields move lower and really start to see the short end of the curve steepen or uninvert, we're going to continue to kind of trade more flattish there, right? I think there'll still be support for corporate spreads overall, but you have to take a step back and realize that there's now, I believe, over $6 trillion of cash parked in money market funds, given how attractive those yields are. So, we really need to see normalized curves in order to see that cash deployed back into the short end of investment-grade corporates and start to see that credit curve steepen.
Jay Diamond: Maria, how much can history teach us about possible performance as we are likely heading into an ease sometime later this spring?
Maria Giraldo: It's interesting. Justin kind of hit upon some of these topics, too, with respect to when we might expect long-end yields to start to go down. Essentially that's going to be tied to when's the Fed going to start easing, which is at this point a moving target. I would say the market, for the most part, was really of the belief--and so were we--that the Fed would start cutting interest rates sometime around March. But of course, the probability distribution around that is very wide, meaning it could be March, it could be May. I would say now we're probably narrowing in on June because of how much the Fed has been pushing back on the start of the easing cycle. And so, we need to kind of think about what if we are in a pause for much longer than people expect and when do we get to the easing part where suddenly rates are going down and there's of duration benefit for investment-grade bonds? So, let's look at the performance of high quality corporates in an environment where the Fed is on hold. What happens then: rates are generally more stable historically, when the Fed is on hold. They're not moving rates up and down, and so we’re seeing interest rates somewhat rangebound, which is what we're looking at now. And that opens the door for investment-grade corporates to deliver exactly what they're meant to provide from a total return standpoint, which is stable income. Now in this environment, we actually just recently published a piece to try to show graphically what it means in a pause and an easing environment. And in this environment where we're in a pause, historically, investment-grade corporate monthly returns have averaged about 1 percent monthly, which is 12 to 13 percent annualized. And then you can compare that to, say, high-yield during Fed pauses, which still delivered positive annualized returns, but those returns are now more in the range of 8 to 9 percent on average, because what happens is at the end of the Fed pause, we typically see that the Fed is gearing up to start delivering rate cuts because now there's weakness in the environment. So, the more credit beta, higher sensitivity, get caught in that environment as it's turning over into a weaker economy. So, then the Fed eventually does turn to rate cuts. Now, investment-grade credit has the potential to not only deliver those stable coupons, but then also benefit from rates declining because the Fed is easing, and because economic concerns trigger a broader flight to safety. And then to Justin’s point, that is the point where you start to see curves normalize. Once the Fed starts lowering interest rates at the front end faster than what we're seeing in the rally at the long end. Now, sometimes the deterioration in the macro environment can be severe enough where investment-grade spreads widen in that environment, which does offset some of the benefit from duration. But even taking into account periods where this happened, particularly like in 2008, right. I mean, this was really a crisis. The Fed was delivering very, very big rate cuts, but the macro environment and particularly market liquidity was at that point very fragmented, and so investment-grade spreads widened a lot. Even taking into account an extreme situation like that, investment-grade corporates still managed to pull through with a 6 to 7 percent average annualized positive return when the Fed is easing. Compare that to riskier markets like equities and leveraged loans, the outcome there is losses. So for us, it seems like in in the next two phases of the Fed and their monetary policy stance, whether they're on hold or easing, you have a good sort of risk-adjusted return story in the investment-grade market that sort of merits some allocation to it from a variety of different investors.
Jay Diamond: Justin, taking all this into account, as the head of the sector team, where are you finding relative value? What are you avoiding? What are your picks and pans right now.
Justin Takata: Starting with probably financials versus industrials, I think we really kind of favor financials relative to industrials. If you think about financials, it's banks and insurance, but I think more specifically comfortable and looking at the Big 6 banks for some relative value. Now, I don't think we've seen the last of the regional bank underperformance or headlines. So, I think we're on the margin of avoiding that go forward at the moment. I would like to see more of the potential CRE stresses and see the market play out and how that might affect some of the deposit issues that we saw earlier last year before really increasing any type of material exposure there. However, I think the large U.S. domestic banks have been through a large wave of primary issuance. And we talked about supply earlier, and I think once you get that supply out of the way, it really allows the market to digest that those new bonds and not really seeing that headwind of supply for the rest of the year. In large form, I think that's a positive technical. I think more on the fundamental side, they have very strong capital positions and I think they've shown their deposit strength vis a vis the regional banks. And so, I think they have potential to outperform industrials. So, switching to ratings, how we look at the BBB and A cohort or within industrials, I look for marginal compression there where BBBs compressed to As. Now, again for the last 2+ months, we've really seen that compression come with BBB tightening versus As. I think what we're going to start to see here is actually As widen, and that's going to help the compression here between BBBs. And a lot of that's going to be primary issuance picking up in a lot of the higher quality names, whether it's M&A financing or just larger cap structures that issue various maturities along their credit curve. And also, they tend to be more liquid, A corporates. So just kind of giving a little bit of a roadmap, how we see some that compression playing out for the next couple of months.
Jay Diamond: Maria, in conclusion, what is your outlook for investment-grade corporate bonds right now, and in credit in general?
Maria Giraldo: I think because we don't see any really major imbalances in the system, we are kind of still 50-50 teetering on whether there is a recession or not. But obviously investment-grade corporates by design, they’re of higher quality. So as Justin has talked about, there’s just a lot of demand. So, you sort of have to be constructive on investment-grade while still acknowledging that spreads are just very tight. So, and I mentioned earlier, on a historical basis, spreads are somewhere in the 25th percentile of historical valuations, and the reality is that spreads are a mean reverting risk premium because business cycles go up and down. And so eventually we are likely going to see some spread widening, but for the near-term, I think there's seems to be quite a bit of support. That said, I think a lot of what Justin talked about is touching on this idea that you still have to be selective to some extent. I mean, I know that there are a lot of concerns, particularly for investors who are diversified, broadly allocated to other sectors, especially like large cap equities. There are concerns out there about concentration in any single company, the possibility that one company's performance might be driving an entire index. And I'm sure that's going to resonate with anyone who invested in the broader large cap indexes. The reality is the same can be true of investment-grade corporate allocation gains that are passive. In the investment-grade corporate bond index, the top 100 issuers out of over 1000 issuers make up 50 percent of the amount of investment-grade bonds outstanding. Then you have some bonds that trade at almost 0 spreads, which basically means you're not getting any additional yield over Treasurys in that particular bond for that issuer. But then there are bonds that offer 3 to 4 percent more yield than Treasurys. So that could be attractive, or maybe there's a reason for that. Maybe that's a potential for a downgrade. I mean, no matter what. I think what Justin is really touching upon is that there is a lot of nuance in the investment-grade space. Where do you want to be positioned? Which sectors do you want exposure to? And while one can have kind of a general outlook of being constructive in investment-grade, there's going to be pockets where you want to be positioned. There's going to be pockets that are going to underperform in a more fragmented environment. And so these are kind of the way that we think about risks, downside risks, upside risks, and we encourage others to take the same type of approach, even in a high quality space.
Jay Diamond: Well, thank you both. This has been a great high-level look at the investment-grade corporate market. But before I let you go, first, Justin, do you have any final takeaways for our listeners?
Justin Takata: Maria brought up a lot of good points, especially on the fundamentals side. I think the takeaway, when we’re kind of combining some of the technicals that I'm talking about and the fundamentals she's talking about, is both can change for bearish reasons. And I think that's important here to stay liquid and nimble in this environment. If Maria's fundamental view kind of plays out or we get some widening, although the fundamental view is strong, I think we want to be in a position to take advantage of that opportunity as spreads widen. Although I've talked a lot about the technicals and why we should be comfortable with IG Credit right here, it's important to keep in mind that the incremental spread you're getting paid for unsecured corporate risk is historically very low. Credit risk spread, if you look at it as a percentage of all in yields that you're buying when you buy a bond, is at 17 percent. That last troughed at 15 percent right before the financial crisis. So not saying that you shouldn't be buying credit here. It's more about just recognizing that you are assigning very little credit risk at the moment to corporate bonds, when you look at the all-in yield and how much credit risk is being attributed to that all-in yield, right, at 17 percent. Now, the counterview to that and I think, again, why we're seeing such support for the sector is that all-in yields are historically attractive. To set some goalposts here, consider that 30-year corporate credit spreads are at the essentially the 0th percentile over the last 20 years, while on the other side, 30-year yields are nearly at the 90th percentile when we look back on two decades. So again, you're not necessarily being paid in the credit spread, but the all-in yield remains attractive. And I think that's really why we've seen such a pickup in ETFs and derivative trading. Overall, given Maria's fundamental view, and I think some of the technicals that look like they'll be steady for quite a while, it looks quite investor friendly for the near future. But again, staying liquid and nimble here I think is extremely important.
Jay Diamond: Wise advice. Maria, any last words from you for our listeners today?
Maria Giraldo: My only last words are to thank our listeners as usual. Thank you so much for reading our research and we really hope this has been informative. And I hope you'll invite me back, Jay.
Jay Diamond: Of course, you guys are always welcome. Now, before we wrap, as I said, we have a listener question to share. This question was addressed to Karthik Narayanan, the Head of our Structured Credit team for Guggenheim Investments and a guest on our last podcast. Here's the question: why do you tend to stay away from asset-backed securities categories like credit card ABS or car loan ABS? And here is Karthik's answer: it's just for relative value reasons. The consumer ABS markets like credit cards, or autos, or unsecured consumer loans, these tend to be more widely followed and have lower duration and lower yields. There's not much of a complexity premium for these subsectors because the collateral is well understood by the market and the deal structures are standardized. We tend to focus on the less widely followed sectors of ABS, where there is a larger complexity premium and better overall reward for the risk of owning fixed income spread product. Well, thanks Karthik. That makes total sense to me. Now, thanks again to everyone who has joined us for our podcast. If you like what you are hearing, please rate us five stars. If you have any questions for Justin or Maria or any of our other podcast guests, please send them to macromarkets@guggenheiminvestments.com and we will do our best to answer them in a future episode or offline. I'm Jay Diamond and we look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, visit guggenheiminvestments.com/perspectives. So long.
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