by Brad Tank, Chief Investment OfficerâFixed Income, Neuberger Berman
In fixed income, we have a reputation for seeing the gloomier side of things. Weâre supposed to be the âvigilantesâ who keep borrowers on the straight and narrow. Because our upside is limited, weâve always got an eye on the downside.
For that reason, we also have a reputation for pricing in economic stress days or weeks ahead of our equity market colleagues.
With that in mind, itâs notable that, over the past two weeks, equities have marched upward on optimism about policy interventions and potential treatments for COVID-19, but credit spreads have actually widened.
Is the bond market warning the equity market not to get carried away, and perhaps even foreshadowing a meaningful correction in stocks?
Differentiation Matters
We think there are a number of reasons why itâs too soon to draw broad market conclusions based on the past two weeks of trading.
First, while itâs not surprising given the unprecedented nature and speed of the shock, credit was not ahead of equity coming into this crisis: Both markets turned south and hit bottom simultaneously.
Second, while itâs true that credit spreads look very cheap relative to equity price-to-earnings multiples, that is not unusual during market or cyclical troughs. At these inflexion points, credit spreads tend to widen and 12-month forward earnings estimates tend to decline further than equity prices, which discount earnings on a far longer timeframe. Rock-bottom interest rates amplify this effect.
The third and fourth reasons exemplify why we need to think about credit as a âmarket of bondsâ rather than a bond marketâdifferentiation matters.
Most equity market indices represent quality and positive momentum. Market capitalization weighting in equities means that the most successful companies of the past decade or so generally dominate. By contrast, market capitalization in bonds means that indices are dominated by the companies that borrow the most.
The top five stocks in the S&P 500 Index are well-known mega-cap tech firms and represent around one-fifth of its total market capitalization. By contrast, the top five issuers in the Bloomberg Barclays U.S. IG Corporate Bond Index are the four largest banks and AT&T, representing approximately a tenth of the Index. The recent lag may simply reflect the fact that bond index constituents are very different, and of lower quality, than equity index constituents.
Similarly, while the spread of the âhigh yield marketâ might look very attractive, looking under the surface reveals major bifurcation. The 17% or so trading at distressed 1,000-basis-point-plus spreads look very different from the rest, 80%-plus of which have rallied impressively and now trade close to par.
Fifth, credit markets are being weighed down by technicals. As we mentioned at the start of April, investment grade issuers have been borrowing like never before. Record U.S. issuance in March was followed by another record of $292 billion in April, with $40 billion issued on the last day alone. The forward calendar for May, typically a busy month, is already crowded. Now the high yield market has burst open, too, off the back of supportive messaging from the U.S. Federal Reserve.
As bond indices re-weight for the end of April, we expect to see an investment grade corporate credit market thatâs bigger than ever, even after $100 billion worth has fallen down to high yield. Lenders are demanding compensation for digesting all that new supply.
And finally, there is the bond math that makes us naturally a little gloomier. You canât look forward to multiple expansion when youâre signed up for fixed income. A bond can trade above par to some extent, but at the end of the day the best case is gravitation back to par.
Chasing the Market
Add up all that, and itâs difficult to glean much from the recent dispersion in equity and credit performance. What we do conclude is that security selection, whether in equities or credit, matters more than ever.
We were an aggressive buyer of new issues through March and much of April, when virtually everything worked and issuers were coming at substantial discounts to the secondary market. We have been quite a bit more selective over the past two weeks, when many new issues have been pricing at a premium to the secondary market, accommodating buyers that missed the opportunity in March and are now chasing the market.
We continue to think that it makes sense to follow the Fed, which means a tilt toward investment grade and maintaining a bias toward durable balance sheets and business models when investing in high yield. We also remain vigilant for the distressed opportunity that is beginning to emerge. A number of these distressed companies will survive and their bonds return to par; conversely, we see areas of high yield, such as gaming, leisure, autos and airlines, where market pricing is too optimistic.
In our view, both of these themes can stand the test of the coming months, whether the lagging credit market turns out to be a canary in the coal mine or a false alarm.
Copyright Š Neuberger Berman
