The current energy in US financial knowledge has been excellent news, and means much less threat of imminent recession. Nevertheless it isn’t making high-quality company bonds any extra engaging — particularly relative to money.
It isn’t clear why, precisely, company bonds are buying and selling at such a slim spreads over Treasuries. Brief-maturity payments, which haven’t any threat of default and are basically money (so long as the US doesn’t fumble its debt restrict and nuke international markets), yield greater than 4.5 per cent. The broad investment-grade bond market pays 5.2 per cent.
One might argue that regular financial development ought to assist firm fundamentals. However the sort of financial energy issues for credit score, as Barclays argues in a Friday observe.
Going by PMI knowledge, the US service sector is rising whereas the US manufacturing sector shouldn’t be. The truth is, the hole between the 2 metrics has not often been this vast, particularly at a time when bank credit is contracting, in line with the Fed’s survey of senior lending officers.
And in these instances — when providers are rising, manufacturing is shrinking, and banks are lending much less — company bonds often commerce at wider spreads to Treasuries. From Barclays:
Spreads seem like buying and selling too tight in relation to present PMIs and US banks lending situations. When banks are tightening lending situations materially and manufacturing PMI is contracting, spreads are often a lot wider, even when providers PMI is increasing. The late-2000 interval appears to be the most effective historic comparability to present situations. Funding grade traded at round 180bp and excessive yield traded round 700bp then (Figure 6).
To check, investment-grade bonds are buying and selling at a 122-basis-point unfold, and high-yield bonds are buying and selling at a 417-basis-point unfold.
The manufacturing sector issues extra as of late, too. Barclays finds that producers make up a larger share of the investment-grade bond index than it did 20 years in the past:
In all, this doesn’t bode properly for company bonds.
Goldman Sachs is turning into marginally extra bearish on high-quality company bonds as properly, although for them principally it’s a matter of the comparability to money. With our emphasis:
Even when long-dated Treasury yields keep anchored round present ranges, we expect spreads are more and more going through binding valuation constraint. That is particularly the case for the excessive finish of the IG high quality spectrum which has to deal with the re-emergence of money as a competing and rewarding various. As proven in Exhibit 2, the yield pick-up provided by A-rated bonds over the 3-month Treasury payments (a proxy for money) has just about vanished. Put one other approach, till the yield curve re-steepens, credit score and period threat taking incentives will seemingly reset decrease.
Due to this, the financial institution’s credit score strategists downgrade higher-quality bonds (rated A-, A and A+) relative to the bottom three tiers of IG:
Downgrading A-rated bonds to a impartial allocation vs. BBBs (from chubby beforehand). In early September, we beneficial upgrading A-rated bonds to an chubby allocation vs. their BBB-rated friends. Two key elements underpinned this view. The primary was relative valuations, as mirrored within the skinny extra unfold premium supplied by BBB-rated bonds relative to the post-global monetary disaster interval. The second was the bigger publicity of the A-rated bucket to Banks (which account for 44% of the index), a sector that we had been recommending an chubby allocation on. As Exhibit 6 reveals, this view has performed out, with A-rated spreads materially outperforming their beta to their BBB-rated friends all through the rally. The place to from right here? We suggest shifting again to a impartial allocation.
What concerning the bonds within the highest two scores tiers, AAA and AA? Effectively, it isn’t clear why we (or Goldman’s shoppers) ought to care. Mixed, they make up lower than one-tenth of the index, in line with ICE knowledge.