Corporate bond valuations: is there still some space left after the big rally?

In the February issue of our monthly Cross Asset publication, we focused on the levels reached by US corporate bond valuations: in a nutshell, at that time, US spreads were back to historical recessionary levels, while European spreads also implied quite a negative scenario more akin to European growth returning to stagnation. Over the following months, however, the picture improved: better than expected Chinese data, the recovery of commodity and oil prices and the ECB’s “QE2” measures were all factors which led corporate bonds to recover to levels more coherent with actual macroeconomic trends.
March saw a strong rally in European corporate bonds; April saw a further, though more limited recovery, while May experienced more of a range trading story rather than a clear trend. BB-rated bonds tightened massively from their mid-February peaks in the 500 b.p. range to their end of April lows, which were just above 300 b.p. (they have since moved back higher, to 330 b.p. at the time of writing). Similarly, B-rated names tightened from highs close to 800 b.p. to their current levels in the 600 b.p. area.

After a strong rally like the very recent one, a natural question always arises: how much space may be left for further tightening, on a pure valuation basis? Are valuations already moving into stretched or tight territory? The same question is relevant for US HY bonds, too, in which a major recovery was driven more by the rebound in oil and commodity prices and the dovish messages delivered by the Fed than by the ECB’s measures. In the following sections we try to answer these questions.

Let's start with EUR HY

Since last summer, the gap between actual spreads and fair value spreads of European high yields has continued to grow and reached a peak of 170 b.p. by mid-February. External shocks, namely the Chinese currency devaluation and the dramatic fall in oil prices, together with the temporary return of idiosyncratic risk, pushed up spreads to levels simply not justified by the results of our regressions based on pure domestic factors. The decoupling of spreads from fair values was particularly evident with respect to sovereign spreads and the growth outlook suggested by leading macro indicators. In fact, sovereign spreads have remained quite low since last summer, showing quite a resilience to fears of a hard landing in China and of higher tail risk due to the fall in oil prices: at the same time, PMI indices continued to suggest
stable real macro growth at around 1.5% for the EMU, despite the renewed risks from global growth. The link with PMI, in particular, shows that at their January/February peaks EUR HY spreads were implying a return to a nogrowth or stagnation economy. The regression shows that over the previous years a similar gap between actual and fair values was also reached in December 2011, when the sovereign crisis was in full swing. At that time, the “cheapness” of EUR HY reached similar levels (160 b.p. vs. fair values).

Then, on 10 March, the much anticipated policy reaction to renewed risks posed by external shocks was finally fully delivered by the ECB. In particular, as we know, the inclusion of corporate bonds in the ECB’s purchase programme took many investors by surprise, and provided substantial support to the subsequent rally delivered by corporate bonds. The consequence of the rally was that the gap between actual and fair values for HY spreads narrowed and is currently only around 50 b.p. This means that with respect to the combination of systemic risk, risk aversion and macro fundamentals, EUR HY spreads still offer a limited positive premium. At the same time, despite the fact that current valuations do not look stretched yet, it is evident when considering the absolute low level of bond yields that, once again, carry becomes the major source of future performance for this asset class. On the other hand, we must also consider that the inclusion of corporate bonds in the ECB’s purchase programme comes at a time when 30% of European fixed income debt has negative yields and another 30% is offering almost no more yield. Therefore, the risk that spreads may “undershoot” fair value levels has to be considered as an option.

Moving on to EUR IG

Since 10 March, non-financial corporate bonds have outperformed financials in the Eurozone. This has mainly been due to two factors. First, the ECB will buy only the first category of debt, or more precisely, non-bank debt. Second, despite the fact that further rate cuts by the ECB appear unlikely for the moment, negative rates have certainly impacted the market’s perception of financial-institution earnings outlooks. On the other hand, we have to consider that the new TLTROs have relevant indirect positive impacts on financials, especially in perspective, relieving the supply of new bank bonds vs. demand volumes. Then, together with the direct supportive effects on banks’ liabilities, the new measures will also have indirect supportive impacts on the quality of banks’ assets. Moreover, the tightening of non-financial spreads is also likely to put downward pressure bank spreads in the medium term.

Having said that, if we consider the result of market action since 10 March, so far the major winners from the measures are non-financial bonds: as we are writing, spreads of BBB-rated non-financials have tightened by 35 b.p., while equally rated financials have tightened on average by just 12 b.p., from 230 b.p. to 218 b.p. The single A-rated companies have shown a very similar trend, though the gap recently partially closed, with non-financials suffering from a recent widening from their lows of 90 b.p. to 100 b.p. OAS. Among financials, senior debt tightened the most on a relative basis, while subordinated debt and Cocos in particular generally lagged, and were more in line than senior debt with poor equity performance.

Results from regressions confirm that financials look better positioned for the future: BBB non-financials in fact look slightly expensive vs. corresponding fair values (135 b.p. vs. fair values in the 140 b.p. area), while BBB financials look a bit cheap at 210 b.p. vs. 190 b.p. fair value). Overall, BBBs look quite close to their fair values explained by equity implied volatility, sovereign spreads and leading macro indicators.

In conclusion, therefore, financials look attractive vs. non-financials in the low IG rated BBB category. BBBs also still look attractive vs. A-rated debt, as the low absolute yield environment is starting to work as a floor to OAS tightening potential in higher-rated sectors.

What about the US?

As we have frequently pointed out, US corporate bond spreads implied a more negative macro scenario than EUR corporate spreads at the beginning of 2016: they respectively implied a return to recession in the US and a return to stagnation in Europe. American spreads were in clear recessionary territory if commodity-driven sectors were included in the computation, while without the contribution of metals & mining and oil sectors the negative implied scenario was less close to a full recession. The major recent news about the gap between leading macro indicators and corporate spreads is their “recoupling”. Manufacturing ISM, thanks also to a softer USD and a better global macro picture, moved back above the 50 threshold in the last two months. Over the same period, the spread rally went very much in the same direction. At the same time, the non-manufacturing ISM recovered ground from a low of 53.5 back up to the latest figure of 55.7. As occurred in Europe, US spreads filled the gap in the implied scenario vs. macro leading indicators.

A check on regression-based fair values for US corporates very much confirms the same evidence that came from the European experience. Fair values have not changed significantly over recent months and therefore the preexisting gap was filled by market action. Also, US spreads still look somewhat attractive in the IG area compared to their corresponding fair values explained by fundamentals (debt and profits on GDP) and by risk aversion/uncertainty indices (equity implied volatility), but the differential is more limited now. The yield carry component, therefore, becomes more relevant in order to drive future performance on the other side of the Atlantic, too.