Corporate spreads continue to narrow despite rising global risks – GlobalData TS Lombard

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Corporate bond spreads are rapidly disappearing worldwide even as global macro volatility and risks rise to unprecedented levels, leaving investors puzzled about what’s driving this phenomenon, according to economists at GlobalData TS Lombard.

“What’s going on with corporate credit? Are spreads in some kind of bubble? And, if yes, is it going to pop soon? Or is this the dawn of a new era in which corporates are now much safer – even safer than governments?” said Davide Oneglia, senior economist at GlobalData TS Lombard.

In his research, Oneglia argued that the current corporate spread tightening is justifiable due to an “unusually favorable backdrop” in which private sector balance sheets have improved dramatically since the Global Financial Crisis.

“After the Global Financial Crisis, the private sector spent years deleveraging its balance sheet, and firms remained reluctant to take on debt even through the following recovery phase,” he said.

The pandemic counterintuitively strengthened this trend as both households and firms accumulated massive savings, allowing companies to repay debt and lower debt-service ratios as economic growth resumed.

A growing narrative suggests we might be witnessing “the dawn of a new era in which the credit of some corporates, mostly cash-rich multinationals, is going to be better than the credit of their respective sovereign.”

Oneglia cited evidence showing that “broad European corporate credit indices have displayed almost as little volatility as their ‘risk-free’ counterparts” and points to numerous examples of corporate debt trading below corresponding sovereign benchmarks in countries like France and across the Atlantic.

High-yield bonds (NYSEARCA:PHB [https://seekingalpha.com/symbol/PHB]) are expected to continue outperforming investment-grade bonds (PFIG [https://seekingalpha.com/symbol/PFIG]), he added, declaring that “investors should free themselves of the idea that HY credit is an inherently risky investment.”

The economist notes that “HY benchmark indices have seen a steady improvement in rating quality over the last 15 years,” while fundamentals such as net leverage and interest coverage are stronger than in investment-grade relative to their own history.

This improvement in fundamentals, combined with typically lower duration for high-yield bonds, “reinforces the bull case amid a difficult environment for duration globally,” Oneglia said.

Despite the positive outlook, the economist identified several risks that could undermine the benign spread environment, particularly the current Chinese macroeconomic slowdown.

“The latest batch of data confirms our longstanding call of a H2 slowdown and highlights the need for Beijing to ‘go’ again with another round of stimulus,” he said.

Additional concerns include potential delays in German fiscal stimulus and unpredictable policy shocks from the Trump administration, which Oneglia described as potential bouts of policy “FAFO” that “could well be a spoiler.”

Lastly, improved liquidity conditions in the market further support the case for sustained narrow spreads. According Oneglia, “Liquidity premia will have to structurally compress amid the rise of portfolio trading, better market-making capabilities at bank and non-bank intermediaries and the rise of HY ETFs, biasing spreads lower.”

In this environment, corporate credit (IGLB [https://seekingalpha.com/symbol/IGLB]), (IGIB [https://seekingalpha.com/symbol/IGIB]) remains attractive, with “even a potential spread widening likely being a buying opportunity” for investors despite the identified risks, he said.

Investors can track bond ETFs in Seeking Alpha’s bond page, here [https://seekingalpha.com/etfs-and-funds/etf-tables/bonds].

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