Are corporate bonds in a bubble?

Gareth Bern, Fixed Interest Portfolio Manager, Prudential Portfolio Managers

As investors note the very low yields of corporate bonds in the United States and Europe, many commentators are asking whether a corporate bond bubble exists. Many of these commentators also conclude that it is likely to burst in most economic outcomes.

Prudential Portfolio Managers Head of Fixed Interest, David Knee and Fixed Interest Portfolio Manager, Gareth Bern, agree with certain aspects of these arguments, but don’t necessarily agree with their conclusions. Their analysis suggests corporate bonds may do better than government bonds in most foreseeable economic outcomes.

“Corporate bond funds have been attracting most of the investment inflows into bond mutual funds, the US equivalents of bond unit trust funds. We have seen investors snapping up the record levels of corporate bonds being issued without seeming to blink, so it is natural to question whether a bubble has started to emerge in corporate credit markets,” Knee and Bern comment.

Understanding the components of corporate bond yields

The yield of a corporate bond can be broken down into two components – government yield and credit spread over and above the government yield to compensate for default risk and the lack of liquidity. These two parts of the corporate bond yield must be considered independently.

Investors must ask if government yields are too low and therefore likely to rise. This deals with the absolute returns from both government and corporate bonds. Another question to consider is whether the spread between corporate bonds and government bonds is too low. This deals with relative returns.

“In debating if there is a corporate bond bubble and whether it will burst, it appears that a number of proponents of the view that there is a bubble are in fact thinking about the first question – are government bond yields too low?” Knee and Bern say.

“They are focused on the fact that the yield on corporate bonds looks very low compared to history and that investors in this asset may face negative capital returns in a variety of economic environments. But how will government bonds perform in these scenarios? Assuming the bursting of a corporate bond bubble goes hand in hand with a bursting of a government bond bubble, it may still be possible for a manager of a global bond fund to do well from holding credit.”

What happens when interest rates increase or decrease?

It is useful to compare returns from credit and government bonds in the biggest US interest rate hiking and cutting scenarios of the last couple of decades.

To do this Knee and Bern extracted the cumulative US dollar returns in the US bond market from government, investment grade and high yield corporate bonds over these periods and concluded that when the economy improves and interest rates increase, it is not favourable for absolute credit returns but beneficial for relative credit returns.

They also concluded that when the economy weakens and interest rates fall, high yield corporate bonds are vulnerable but investment grade credit does well on a relative basis.

“In the case of falling rates, generally in response to a recession, common sense would suggest that as corporate balance sheets worsen, credit ratings are downgraded and defaults increase, and corporate bonds will do poorly on a relative basis. But one might expect absolute returns to be high,” explain Knee and Bern.

However, the data is in fact mixed. Investment grade corporate bonds matched or beat government bonds in two of the three largest rate cutting cycles of the past two decades. On both of these occasions - the early 1990’s and the dot.com bust when the recession was caused by a cyclical downturn in response to high interest rates that aimed to slow an overheating economy - investment grade bonds did well in absolute terms and kept pace on a relative basis.

Investment grade corporate bonds only massively underperformed government bonds in the recent financial crisis. The unwinding of excessive leverage in the bank and asset management industries produced the worst outcome for credit assets since the Great Depression.

In the case of high yield, recessions tend to hit harder; and in two of the three periods of monetary easing high yield credit performed poorly both in absolute and relative terms.

What about the spreads on corporate bonds?

If the additional yield over government bonds is particularly low now, the margin of safety is more limited than in the past. Knee and Bern believe this would mean worse outcomes than historically has been the case.

Knee and Bern examined the average corporate spreads at the start of each of the historic interest rate cycles to determine if, relative to these periods, present day spreads are compressed. “The data shows current credit spreads are not low compared to the starting points of previous interest rate cycles. They are in fact substantially higher, particularly in lower-rated bonds. This suggests that there is a greater rather than a lower margin of safety or valuation buffer against adverse economic environments and changes in interest rates,” comment Knee and Bern.

They also discovered that underlying credit metrics of investment grade corporates suggest a relatively strong corporate sector. This provides further support for investment grade corporate spreads.

“When we combine these factors with the current pressure on wages, which helps corporates to manage costs, we believe it adds up to a position of relative financial strength for investment grade corporate,” add Knee and Bern.

While the high yield sector does not exhibit the same relative financial strength as the investment grade sector, when compared to 2001 or 2008, it certainly is on balance in no worse a position. Importantly for high yield issuers, they have taken advantage of the demand for corporate credit to lengthen their maturity profiles to ensure that they are not as exposed to having to refinance their borrowings in the near term. This was one of the main risks issuers were exposed to in the most recent financial crisis.

What about the large investments into credit markets?

The large investment flows into the credit markets, particularly in 2012, are also frequently pointed to as evidence of the formation of a bubble in credit markets.

Global fund flows have experienced a massive increase in allocations to credit in 2012. To create a bubble in credit markets though, investors would expect that demand for credit would need to exceed supply and evidence of this would manifest itself in historically low credit spreads.

“While it may be true that demand might have exceeded supply on a net basis, in other words, adjusting new issuance values for what is actually a refinancing of maturing bonds, there certainly has been a supply response as issuers have sought to take advantage of the low absolute yields in the market.”

“The fact that credit spreads do not appear low on a historical basis negates the argument that the increase in demand has caused a bubble in credit markets,” conclude Knee and Bern.

What does this mean for investors?

You cannot dismiss historical returns. The facts reveal that corporate bonds, especially high yield corporate bonds, do as well, if not better than government bonds in rising interest rate environments. In interest rate cutting cycles, high yield corporate bonds are vulnerable but investment grade credit is robust on a relative basis.

Prudential’s Global High Yield Bond Fund is therefore overweight investment grade and high yield bonds relative to government bonds. Recognising that high yield corporate bonds are vulnerable to a recession, Knee and Bern note that consensus is a long way from expecting such an outcome in the US.

“We also think we are protected by the wider credit spreads than previous cycles as well as by the strong underlying credit metrics for investment grade issuers. Low default rates reflect the relatively healthy state of corporate balance sheets and for us this implies that if there is a swing back towards a recession, the performance drag from our overweight high yield will be contained.”

The scenario where rates remain on hold for an extended period will continue to be positive for credit. The longer it persists, the more investors will find the additional yield from credit attractive. Corporates are likely to remain relatively conservative in the face of elevated economic uncertainty, avoiding the irresponsible behavior that led to their downfall in previous cycles.

“We therefore believe that credit wins outright in two of the possible economic outcomes – stable or rising rates,” say Knee and Bern.

Only a recession or more monetary easing should provide a challenge to credit. Even then, Knee and Bern believe investors are currently more protected than in the past due to the higher spreads on credit. They therefore support an overweight credit view for any investors wishing to hold bonds as a part of a strategic allocation in their international portfolios.

The local market has also seen supply and demand dynamics improve considerably in the last year. While credit spreads have continued to fall from their elevated levels in 2009 and 2010, they do still offer fair value.