Like other core fixed income sectors, investment grade corporate credit has had a tough start to the year. After losing 1.0% last year, investment grade corporate debt is off another 2.4% (through January 14) in 2022. However, the paper losses this year (and last year frankly) are not due to declining credit fundamentals or deteriorating credit conditions. To take advantage of low interest rates, shore up balance sheets and extend maturities, corporate CFOs have issued record amounts of debt over the last two years. By doing so though, corporate borrowers have increased the interest rate sensitivity of those securities. The interest rate sensitivity of the corporate credit markets (as measured by duration) remains near all-time highs and is higher than even the U.S. Treasury index. As such, the increase in Treasury yields has pushed yields on investment grade debt higher as well (blue line below).
“Corporate credit markets have come under pressure this year,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “And while higher yields make the sector a bit more attractive, we think valuations still aren’t very compelling given the increased interest rate risk.
The positive take on the performance of the investment grade bond market so far this year, and as seen in the LPL Research Chart of the Day, is that spreads (orange line) are unchanged despite a big jump in Treasury yields, heavy new corporate issuance and weaker equity markets. The lack of movement in spreads speaks to the overall favorable credit conditions supporting valuations. Moreover, as mentioned, corporate credit fundamentals and companies’ ability to service debt have improved. Revenue, free cash flow, profit margins, debt, leverage, and interest expense all have shown improvements during 2021. Unfortunately all these positives are already priced in, in our view.
Valuations should remain well contained as there are a number of large price indiscriminate investors that need to own corporate debt (banks, insurers, pension funds, etc.) and foreign investors can still pick up additional yield in our markets. However, despite higher yields we remain neutral on investment grade corporate credit. The increased interest rate risk and lack of additional compensation for holding corporate credit limit the attractiveness, in our opinion.
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