At 93bp, investment grade corporate spreads are tight when compared to historical levels. Yet, demand has been robust despite a record issuance of investment grade debt in Q1 2024, helped by higher treasury yields. Any easing by the US Federal Reserve this year, which should lead to lower yields (especially in the front end of the yield curve) would be positive for fixed income investors.
Fundamentals Broadly Resilient
Investment grade company balance sheets are strong despite headwinds. Given the higher rate environment, many companies have chosen to de-leverage to reduce interest expense. According to Citigroup, interest coverage ratios have declined over the past year, although they remain a healthy 9.2 times as issuers refinance debt at higher overall interest rates. Corporate leverage was persistent at just 1.95 times (gross debt as a multiple of trailing 12-month EBITDA), similar to year-ago levels, but still well below the June 2022 high of 2.56 times. We expected companies to continue to refinance debt at a robust pace given the warm reception new issues have received from investors.
Demand Is Strong
Investment grade corporate new issue activity for the first-quarter of 2024 was very active. Through March 28, $540 billion of new issues were brought to market, 31% higher than the average of the past five years. Despite this deluge of supply, investment grade corporate spreads tightened 9 bps to 90 bps currently (as measured using the Bloomberg US Corporate Index). Investors are attracted to the higher yields (5.5% yield to worst) which are at the 91st percentile of the past ten-year range. Strong demand is reflected in fund flow data, where the Investment Grade Credit category saw inflows of almost $33 billion over the past three months according to Goldman Sachs.
Opportunities in Investment Grade Credit
While investment grade spreads are near historically tight levels, we believe there are opportunities for incremental gains. Bank credit spreads are still wide to Industrials and we expected they will tighten to levels inside Industrial debt. The banking sector is higher rated than industrials, with the typical bank generally rated AA or A, while industrials are generally rated A or BBB, a full letter grade lower. In addition, banks are highly regulated and capitalization ratios are approaching historical highs. Unless there is stress in the banking system (Figure 1), the ratio of banks to industrial bond spreads is typically less than 1.0, owing to better quality credit. Currently this ratio is at 1.1 and we expect it to fall below 1 over time. This ratio is off its recent high when it touched 1.3 during the collapse of Credit Suisse and Silicon Valley Bank. Regulators quickly stepped in to resolve these and other smaller bank failures. We expect more banks to fail, particularly very small banks, as interest rates remain high and stresses persist in the commercial real estate market. However, as noted above, bank capitalization ratios are generally quite high and balance sheets are broadly sound. Still, in the current market environment, security selection matters more than ever and we believe this opportunity will ultimately reward patient, selective investors.
Figure 1: Ratio of Financial to Industrial Credit Spread
Source: ICE Data
Another opportunity that exists in the investment grade corporate market is in shorter maturity debt. While longer dated (greater than 10 years to maturity) corporates offer spreads near the 10 year tights on an OAS basis, shorter debt (less than 10 years to maturity) are priced at or near the median. In addition, we expect longer-dated issuance to increase when interest rates eventually fall, which could be a catalyst for wider spreads at long maturities should this eventually happen. Hence, we find more value in shorter-dated bonds and have overweight debt with maturity less than ten years in our portfolios.
Figure 2: Investment Grade Corporate Spreads 10-Year History (BPS)
Source: ICE Data
Sector Strategy
From a sector perspective, we still favor banks and financials. In particular, regional banks continue to offer spreads wide to the “Big 6” banks. This difference, which widened significantly a year ago due to the fallout from the banking failures, is still too wide in our view. The issues with deposit flight and loan quality affecting regional banks have largely been priced by markets. We prefer the “Super Regionals” versus the smaller regional banks as these banks have diversified revenue streams which lowers the volatility of earnings.
Other preferred sectors include Telecommunications, where the large issuers have begun to de-leverage with free cash flow. Capital expenditure spend on network build is largely behind these issuers, and with higher interest rates, lowering their debt balances makes the most financial sense. Finally, Electric Utilities, especially first mortgage bond issues, provide stable consistent returns given the regulated structure of their businesses.
Conclusion
Given a resilient economy, healthy fundamentals, and high yields, we expect robust demand for investment grade corporate debt from investors to keep credit spreads, which are near historical tights, range bound for the foreseeable future. We are in an environment where the Fed Funds rate has likely peaked, and eventual easing will be a positive for fixed income investors. In addition, lower short-term rates in the US should also stimulate demand from foreign investors as hedging costs have been a significant hurdle over the past year, a potential further source of stability for the market going forward.
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