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Here’s some good news: tight spreads in U.S. investment-grade and high-yield bonds are finally starting to give way.

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Throughout 2017, there was “a general compression of credit spreads across the board, with very little differentiation of risk at the sector or security level,” says Andrew Kronschnabel, portfolio manager at Logan Circle Partners in Philadelphia, and co-manager of the Renaissance U.S. Dollar Corporate Bond Fund.

By mid-November, the market started “pricing risk more appropriately, [with] lower-rated, less fundamentally secure companies hav[ing] their debt prices decreasing,” Kronschnabel says.

Examples of companies included Frontier Communications and Teva Pharmaceutical Industries—both highly leveraged companies, says Kronschnabel. He also pointed to Sprint Corporation, which saw a potential merger with T-Mobile fall through in early November.

The credit market’s repricing extends beyond telecoms and pharmaceuticals, however.

Read: More to U.S. corporates than interest rates

“What we’re seeing is differentiation among sector and issuer in terms of bond pricing,” says  Kronschnabel. “Good companies’ bonds are increasing in value or staying [level], and companies with challenges have bond prices that are decreasing in value quite dramatically.”

Recent dramatic drops are the result of “somewhat rich,” valuations, he adds. For example, in high yield this year, yield lows have been about 5.4%—“a very high valuation for U.S. high yield,” he says.

Yields for investment-grade bonds tell a similar story, says Kronschnael: “We had credit spreads around 90 basis points […] relative to U.S. Treasurys, which is close to post-2008-crisis tights.”

When that occurs, “We’ll attempt to pick the winners and losers,” says Kronschnabel. “That’s where we can make a difference.”

Read: Look beyond U.S. for best investing opportunities: report

Effects of tight spreads

Typically, within a market of tight spreads, “when companies misstep, their bonds get punished dramatically,” says Kronschnabel. He aims to reassess companies if their valuations change.

“We sometimes say in the corporate bond market: there are no bad bonds, just bad prices,” he adds, explaining that a bond repricing might catch his eye if it appropriately reflects risk. For example, a high-yield bond that trades at 4% might become more attractive at 6% to 8%, depending on risk.

“We’re starting to see the pricing of risk become more appropriate, which creates a lot of opportunity for us to […] avoid situations that are negative and then to evaluate situations after they’ve repriced,” says Kronschnabel.

The backdrop is positive. As of mid-November, he called overall macroeconomic fundamentals “supportive.” In fact, he added, “The third quarter was the best quarterly earnings generation in U.S high-grade markets since 2011.”

Those factors support Kronschnabel’s view. “Yes, spreads are closer to the tight end of the recent range,” he says, “but we don’t think that’s unwarranted by the backdrop or underlying fundamentals within the marketplace.”

Also read:

Low-rate strategies for fixed income

Global economy has ‘room to run’ in 2018: BlackRock

This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.

Originally published on Advisor.ca
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