Amid a relentless sell-off in the US Treasury market year-to-date, little attention has been paid to the US IG corporate bond market and the numerous dynamics at play there. In the below piece, Rick Patel, Portfolio Manager for US Investment Grade Fixed Income, takes a closer look at the various trends he sees emerging across US IG, and he details why there is a compelling case to be made for and against the asset class in the current market environment.
Glass Half Full
Starting with arguments in favour of the asset class, Rick’s bullish views on US IG are threefold.
1. Lighter supply: in the space of a few months, supply dynamics have shifted from being a key headwind for US IG, to one of the most supportive technicals for the asset class. As higher yields weigh on the incentive for corporates to issue new debt (Chart 1), and equity valuations start to come off, the expected supply for US IG has fallen materially such that the 2022 number is now projected to be the lowest it has been since 2014 (Chart 2). Although we saw some front loading in Q1, market and sell-side estimates point to the overall supply numbers for 2022 to be in the region of $1.2bn, revised down from $1.5bn at the end of last year.
Chart 1: US IG index yield now trading far above the 10-year average; less compelling for issuers to issue new debt at this level
Source: Fidelity International, BofA ICE, Bloomberg, 12th April 2022. US IG index yield is represented using the C0A0 Index. Yield refers to the yield to maturity.
Chart 2: Forecasted US IG supply for 2022 downgraded from previous estimate
Source: Fidelity International, BofA Global Research, 8th April 2022.
2. Reduced M&A: following a record-breaking year for new deals, M&A volumes fell in the first quarter of 2022 against market expectations. Dealmakers are seemingly more cautious than previously anticipated amid rising yields, greater market volatility, and increased scrutiny from anti-trust authorities. Although there are still some sizeable debt-funded M&A deals on the horizon (e.g., Oracle Corporation’s $28bn acquisition of Cerner Corp announced in December 2021), the overall reduced supply resulting from fewer M&A transactions should be a tailwind for US IG going forward.
3. Valuations: having traded in a low single-digit range for the most part of 2021, spreads in US IG drifted steadily wider throughout Q1 2022, with the index-level OAS reaching a 16-month wide of 152bps in March. While we have seen a recovery to 125bps as of mid-April (Chart 3), dispersion remains high across US IG sectors and hence offer attractive value propositions relative to other sectors. Of note, the consumer, autos, and banking sectors have all lagged the recent rally, and look attractive relative to the telecom and technology sectors for example.
Chart 3: US IG valuations are attractive on a 1Y basis, spreads have recovered from the March-2022 sell-off
Source: Fidelity International, BofA ICE, Bloomberg, 12th April 2022. US IG Option Adjusted Spread (OAS) is represented using the C0A0 Index.
Glass Half Empty
Taking a bearish view, we touch on four key points for why one might be less constructive on US IG going forward.
1. Recessionary risks: risks of a recession in the US are rising and are a key headwind for US corporates should they materialise. One of the main drivers is the geopolitical headwinds that the US faces (Midterm elections, contagion from Russia’s war in Ukraine), which would directly impact its outlook for growth. Additionally, with the US Fed currently embarking on a policy tightening cycle, there is the increased possibility of a recession which (although not a near-term risk in our view), would have negative repercussions for US IG should it eventually materialise.
2. Hiking cycle trends: analysis of previous rate hiking cycles suggests that sectors tied to housing, autos, consumer goods and banking are most likely to experience a slowdown relative to those that are tied to capex and industrial demand during periods of rising interest rates (Chart 4). With this in mind, we might expect to see some weakness across US IG sectors that have a greater sensitivity to rate hikes given the current market cycle.
3. Sector-specific headwinds: large sectors in the US often face nuanced headwinds, which pose a significant risk to the fundamental outlook for IG corporates within the sector. In the pharmaceutical space for example, many large issuers face significant risks to profitability owing to periods of ‘patent cliffs’ wherein their profits start to fall as competition rises following the expiry of a product patent. In the Telecomms and Cable sectors, many corporates face headwinds stemming from direct competition between broadband and telecom providers. While these risks are not cycle-specific, they can pose a risk to corporate margins and so warrant a close eye on through ongoing fundamental research analysis.
4. Private Equity (PE): PE activity continues to pick up pace, striking a new record in 2021. Despite a fall in activity in Q1 2022 relative to the previous quarter, there continues to be significant interest from the sector and activity still makes up a significant portion of overall M&A deals. Overall, we expect to see PE firms continuing to buy what they can at the expense of bond-holders, posing a risk to US IG investors.
Chart 4: Certain sectors are more sensitive to a rate hike environment than others
Source: Fidelity International, Census Bureau, FRB, Cass Information Systems, Inc., Haver, Bloomberg Finance LP, Deutsche Bank, 11th April 2022
The Bottom Line
One of the hallmarks of our US Investment Grade bond strategy is to manage risk with a tactical, nimble, and flexible approach. With volatility across fixed income markets likely to remain elevated in the near term, and dispersion likely to continue rising across sectors and ratings, having the flexibility and the resources to identify value opportunities across the broad US IG opportunity set is crucial, as it helps us to generate superior risk-adjusted performance for our clients. Fidelity’s team of sector-specialist analysts and traders play a crucial role in identifying opportunities before our competitors, thus enabling us to deliver this active style of management.
Furthermore, when we consider some of the risks that the US IG sector faces, as outlined above, downside protection becomes an even more important aspect of portfolio management. Working closely with our teams of analysts enables us to not only select the best names for our portfolios, but it helps us to avoid the worst individual credits, thus providing greater protection for our portfolios. Working closely with our analysts also means that we have real-time awareness sector-specific headwinds and other drivers of potential weakness.
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