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Financial journalist Chuck Jaffe, the host of MoneyLife podcast, recently spoke to Natalie Trevithick, director and head of investment grade corporates at Payden & Rygel, a global asset management firm, about the U.S. corporate bond market. Here are excerpts from that interview.
Chuck Jaffe: We've got credit spreads pretty close to their year-to-date highs. How much run do we still have?
Natalie Trevithick: That's the question everybody's asking. Corporate yields are now 6.25%. They're made up of the underlying U.S. Treasury component plus that spread over Treasuries. That spread has widened out recently and it's now around 130 basis points, that's on the tighter side. But if you look from a yield perspective, that's nearly a 100 basis points higher year-to-date. I think most investors are just looking at that 6.25% yield on corporates and saying, “Now is a good time to start buying these higher quality investment-grade corporates and pick up incremental yield from Treasuries.”
Chuck Jaffe: But is it really a good time? You've got inflation where it is, you've got interest rates that have stayed higher for longer, you've got the threat of a recession. We have seen the Magnificent Seven hurt a little bit but their bonds have shrugged it off.
Natalie Trevithick: Exactly. Sometimes what’s potentially detrimental for an equity holder can actually be positive for a bond holder. These big tech companies still have huge cash balances. They're fundamentally strong from a balance sheet perspective, so their credit spreads aren't going to move on some of this equity moving behavior. We're also focused on the macroeconomics as bond investors: We got third quarter gross domestic product (GDP) of 4.9%, above expectations of 4.5%. It shows the consumer is strong – consumer spending accounted for 2.7% of that total. That makes us a little bit more optimistic.
Chuck Jaffe: This year a very small segment of stocks are driving the market Has the corporate bond side been broader?
Natalie Trevithick: In bond investing, there are many more issuers than in the equity market. I'm looking at thousands of different issuers that can have multiple bonds outstanding. Most of them have a very wide debt stack, so you can decide if you want to get two-year bonds and lock in these high yields for a shorter amount of time, or extend out to 10- or 30-year bonds. And even though their yields may be a little lower there than they are in the front end, given the inverted yield curve, you're locking in these higher yields for longer. Individual name selection does matter, but you can also just buy the index via an exchange traded fund (ETF).
Chuck Jaffe: I saw a commentary in which you were basically making a case that we're living in a bond version of Barbieland, that it's not the real world, that the real world is waiting for something to change and something to crack. Explain if the analogy and if it still holds today?
Natalie Trevithick: The analogy still holds in that we saw a big credit rally post the resolution of the debt ceiling in early June, and investment-grade corporate bonds seemed to be impenetrable from a spread perspective. So even when we were seeing yields move higher, investment-grade corporate bonds spreads were holding on well. And they do seem to be shrugging off a lot of things that could be happening in the real world, including geopolitical events and the threat of the recession, which would maybe make investors want to be more cautious going down the risk spectrum into corporates from just Treasuries. The market seems to exist in this world with rosy glasses on. Can they maintain living in Barbieland or will they have to face the real world like Barbie and Ken did, and all of a sudden be hit by these real-world surprises and take a hit to bond spreads.
Chuck Jaffe: What do investment-grade corporates typically do in recessionary conditions?
Natalie Trevithick: Spreads are going to widen, and their level today is around 130 basis points. Getting out to a wide of 200 basis points would be quite recessionary. Over the past couple of years on points of high volatility, we've reached 165, but investors tend to see that as a buying opportunity and quickly stepped in and drove spreads tighter again. We're really not in the recession camp – we’re in the “no landing” camp where growth remains too strong for the Fed to stop raising rates for the near term. We think we can see the re-acceleration of growth again, like we're seeing in GDP and not stall out. We see a pretty good runway for corporates looking ahead.
Chuck Jaffe: At what point do you start to change at least your maturity picture? Right now, people are looking for the yields, but we've got an inverted yield curve. When will you start to lengthen maturities in anticipation that the rate picture is changing?
Natalie Trevithick: I think now is the time to do it because we have seen the curve start to uninvert. There's only about 18 basis points differential between the two-year Treasury and 10- year Treasury, just 18 basis points lower than that, and we have an upward sloping Treasury curve from tens to 30s. So, we are seeing more demand for 10- and 30-year corporate bonds because people do want to lock in these higher yields for longer periods.
But on the flip side, we're seeing corporations want to issue more short-term debt, two-, three- and five-years because, even though they may be paying higher interest payments today, they don't want to lock in those rates for longer. So, there's a little bit of a bifurcation between what investors want to buy and what corporations want to issue into the market.
Chuck Jaffe: Is there a benefit to looking internationally when you're looking at corporate bonds, given the strength of the stock market In the US and the clean regulatory picture?
Natalie Trevithick: We do look at corporate bonds globally. The U.S. is by far the biggest market, accounting for over 80% of U.S. dollar denominated bonds. But we also think the U.S. is a better macroeconomic environment. We are seeing cracks of weakness in Europe, so that's making us more cautious. Germany in a recession, we see further signs of stress in the UK, but other areas we do like are some of the Canadian bonds, Canadian banks and Australian banks. We do see value globally on a name specific basis, but our preferred domicile right now is the U.S. just given our stronger outlook here.
Chuck Jaffe: What would it take to change that? I assume it would take something significant.
Natalie Trevithick: Exactly. That's another part of the Barbieland – we just seem to be shrugging off geopolitical risks. Not only the latest war in Israel, but Russia and Ukraine, and even going back beyond that, people have a tendency to be very resilient when looking at these things. The market is still pricing in some Fed cuts next year. We don't think that's really going to be in the cards given the strong growth picture. But if the Fed were to cut and we were to see underlying interest rates fall, that would actually be positive for bond investors and produce more positive returns. So, in a way, bad news could be good news for credit investors.
Chuck Jaffe: You invest in investment-grades bonds so you wouldn't really be worried about defaults, but are you worried that some things that are investment-grade get downgraded to junk status? Is there a reason why we haven't seen more of that as we've been in this higher for longer rate and inflationary environment?
Natalie Trevithick: Yes, because this is the most, well telegraphed recession never to have happened. People were predicting a recession last year, for earlier this year, or even by the end of this year. Management teams have had a lot of time to think about how they should position their balance sheets. We've seen companies take actions as necessary, cutting their capital tax, for example. Some companies have put on hiring freezes or did layoffs, as we saw in much of the tech sector. If we were to have a recession, it would not take anybody by surprise. Also, companies were able to access very cheap capital post the pandemic with interest rates of one, two or three percent. So, they've already pre-funded a lot of their maturities and they extended their maturity profile by issuing 10- and 30-year bonds at that time.
One thing we look at, which is pretty interesting, is the average coupon on all outstanding debt. That's really only gone up about 50 basis points from its lows in March 2022, where the average coupon was 3.6% on the $9 trillion corporate market, and now it's around 4.1%. You have to understand these companies aren't refinancing their entire capital structure each year. They're doing about 10%. They still have a lot of lower coupon bonds in their credit profile, which doesn't mean they're taking a big hit all at once. They're only incrementally increasing some of their financing costs.
This material reflects the firm’s current opinion and is subject to change without notice. Sources for the material contained herein are deemed reliable but cannot be guaranteed. This material is for illustrative purposes only and does not constitute investment advice or an offer to sell or buy any security. Past performance is no guarantee of future results.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.