An investor scramble to lock in returns before the Federal Reserve cuts rates is expected to sustain a rally in the U.S. corporate bond market into the second quarter, with one strategist saying it may touch levels not seen in three decades.
Credit markets are being overwhelmed by a buying frenzy, as investors bet the Fed will engineer a soft landing, taming inflation without causing a recession, and then cut interest rates later this year to support growth.
“On March 21, the premium paid by companies over Treasuries, called credit spreads, on investment grade rated and junk-rated bonds touched their tightest levels in two years – at 91 basis points and 305 basis points, respectively.”
Large bond investors such as insurance companies and pension plans are seeing an influx of money from their clients looking to capitalize on higher interest rates, leading them to seek corporate bonds, credit strategists said. But there may not be enough new issuance to go around.
“In the first quarter, for example, investment grade companies raised a record $538 billion – that’s 40% of the $1.3 trillion of bond supply that was expected for the entire year, according to data from research firm Informa Global Markets. In a sign of strong demand, new offerings have been three to four times oversubscribed on average.”
Morgan Stanley’s credit strategist Vishwas Patkar likened the current market to conditions in the mid-1990s when after four cuts in 1995, the Fed kept rates high for an extended period. “Credit remained very resilient, and spreads hit their modern era tights of 56 basis points even as rates were higher,” he said.
“The S&P 500 posted its strongest first-quarter performance in five years on Thursday despite U.S. stocks closing little-changed.”
Patkar said there was a chance spreads could go as low as 75 basis points, levels not seen since the 1990s if a soft landing was achieved. Earlier this month, he moved his base case year-end spread target to 95 basis points from 125 basis points.
“He’s not alone. Bank of America strategists expect spreads to tighten to around 80 basis points over the next month, closer to the 77 basis point level touched in 2021. They are, however, sticking to a 6-month spread target of 100-120 basis points.”
Steering Corporate Debt Markets
The robust demand for corporate debt brings a silver lining for companies, enabling them to secure funding at lower costs. Nonetheless, certain investors caution that the narrowing spreads imply diminishing returns for the risk they undertake in purchasing such debt.
Hans Mikkelsen, a credit strategist at TD Securities, highlighted that the gap between credit spreads on BBB-rated bonds and those with A ratings has reached historic lows. This indicates that credit investors are not factoring in macroeconomic risks, such as a potential downturn in the U.S. economy. Mikkelsen, in a report dated March 15, sets a six-month spread target at 130 basis points.
John Lloyd, overseeing multi-sector credit strategies at Janus Henderson Investors, expressed skepticism about the attractiveness of corporate credit at current spread levels. He stated, “As an investor, it is hard to argue there is a lot of value left at these spread levels, so we are underweight corporate credit.”
Mike Griffin, co-head of corporate and municipal teams at Conning, emphasized their approach to mitigating downside risks by diversifying investments across various asset classes. He noted their preference for debt issued by high-quality companies to avoid potential liquidity issues in a downturn.
Insights into Market Momentum and Bond Dynamics
Despite the risks, experts on Wall Street assert that the market’s momentum is poised to persist in the near term.
Insurance firms are acquiring corporate bonds to align with an uptick in obligations, driven by higher interest rates prompting heightened sales of annuities, which are contracts providing a regular income stream.
In 2023, total U.S. annuity sales soared to a historic high of $385.4 billion, marking a 23% increase compared to the previous year, as reported by industry authority LIMRA.
According to Conning’s Griffin, insurance firms and pension funds are actively seeking to hedge their liabilities by investing in high-coupon-paying assets such as fixed income, with some pension funds considering a shift away from equities.
Furthermore, the reinvestment of coupons paid by companies on their existing bonds is contributing to the demand.
Goldman Sachs projects that investment-grade and high-yield rated bonds will yield total coupon payments of $463 billion in 2024. Should all these payments be reinvested, they would absorb 77% of the anticipated $600 billion in net issuance for the year.
“Strong technical factors continue to drive market dynamics, with demand for investment-grade credit remaining robust while supply is gradually tapering off from its record pace,” remarked JPMorgan strategists in a report issued on Tuesday.
The bank revised its year-end spread target for investment-grade rated bonds downward by 30 basis points to 95 basis points.
