Weekly Bond Bulletin

8 October 2020

Retracing our steps

Market volatility has proven short-lived for investment grade credit markets. With retracements in index-level spreads happening so quickly, where can investors find value?

Fundamentals

The recent market volatility was driven by uncertainty around the US election, as well as broad concerns about the impact of higher Covid-19 case rates in several regions. However, investment grade corporate fundamentals are in reasonable health given the circumstances. While it is clear that leverage is rising, net issuance is not rising as fast as gross: companies have built up liquidity war chests from recent issuance, and so far this has broadly been kept back and not used for bondholder-unfriendly activities such as M&A. The downgrade environment also provides some comfort: the rise in fallen angels has flatlined since May, and the cumulative proportion of the market downgraded to high yield in 2020, at under 3%, is well below the initial expectations of market commentators. The ratings agencies are indicating that they will give issuers on negative outlook 12-24 months to get their EBITDA run rate back up and to improve their balance sheets.

Quantitative valuations

The recent risk selloff presented only a fleeting opportunity to buy investment grade credit at marginally more attractive levels. Spreads backed up by 10 basis points between 16 and 25 September, to 1.39%, but have since fully retraced to levels last seen at the beginning of March. As such, valuations at the sector level look challenged, especially compared to high yield markets. However, we still see opportunities within the investment grade universe, with spreads in certain sectors still looking elevated on a relative basis when adjusted for the shape of the yield curve and rates volatility. For example, hybrids, with an option-adjusted spread of 255 basis points (bps), remain 80 bps above their one-year tights, having retraced less (around 65%) than the broad index. (All data as of 7 October 2020.)

The recent selloff was a limited buying opportunity, but some sectors have room to tighten

Source: Barclays Live; data as of 7 October 2020. IG: investment grade.

Technicals

Demand for high quality, positive-yielding credit remains as strong as ever, which is providing a backstop to the market. Foreign buyers whose domestic markets are negative yielding are being drawn to US investment grade credit; central bank purchase programmes are continuing to provide a powerful tailwind despite a drop-off in purchases by the European Central Bank; and risk appetite in general seems to recover quickly from bouts of headline-induced volatility. The higher beta parts of the credit market are in particularly strong demand, as indicated by the oversubscription on recent subordinated deals (where large amounts of supply have been well-absorbed).

What does this mean for fixed income investors?

It looks likely that uncertainty is here to stay right up until election night – and possibly beyond, as markets start to consider the implications for fiscal policy in the following months. This is becoming the key headline risk to markets in general, alongside virus and vaccine-related news. However, the ever-powerful technical environment means any volatility is currently proving short term. We therefore expect spreads in investment grade credit to remain tight over the medium term, making index-level investing challenging. However, looking beneath the index at attractively valued, in-demand, high-beta sectors (such as additional-tier one and hybrid securities) could be a rewarding strategy for active investors.

About the Bond Bulletin

Each week J.P. Morgan Asset Management’s Global Fixed Income, Currency and Commodities group reviews key issues for bond investors through the lens of its common Fundamental, Quantitative Valuation and Technical (FQT) research framework.

Click here to read more about our FQT capabilities


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8 October 2020
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