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(Runtime: 4 min, 27 sec; size: 3.84 MB)
Andrew Kronschnabel, head of investment-grade credit at MetLife Investment Management, and portfolio manager for the Renaissance U.S. Corporate Bond Fund.
The Federal Reserve has had an enormous impact in the corporate bond markets in 2019. The initial pivot by Jerome Powell in early January and subsequent dovish comments ever since has helped to fuel a risk rally in all risk assets, corporate bonds included. On Jan. 3, before Powell’s initial dovish pivot that came really just a few weeks after the most recent rate hike on Dec. 19, 2018, that day marked the widest levels of the year—the worst levels of the year for investment-grade and high-yield corporate credit spreads, at around 150 basis points for investment-grade and around 550 basis points for non-investments grade. Since then, through the end of July 2019, high-grade spreads rallied an impressive nearly 50 basis points, generating over 400 basis points of total return relative to Treasuries, and 10% total return absolute. Similarly, U.S. high yield has returned over 6% better than U.S. Treasuries and nearly 10.25% total return, with spreads rallying almost 120 basis points since that January 3rd date.
Keep in mind these assets have rallied despite declining fundamentals in the corporate market and increased friction and an uncertainty related to trade tariffs. The rally has occurred nearly in a straight line, really with only the month of May as the only month of under-performance for corporate bonds relative to Treasury securities.
It also hasn’t been limited to corporate bonds. It’s very tough to find a single asset class that is lower on the year. The expectation of easy money and accommodative central bank, or what is called the Powell Put, has fueled financial assets and commodities to impressive levels.
For all its efforts, though, central banks cannot print corporate earnings, and that’s where we are laser focused right now. The second and third quarter of 2018 earnings growth was positive to the tune of nearly 25% each quarter. Those are very difficult base effects to compare against and we are concerned that earnings growth in upcoming quarters will struggle to be positive.
The real question we wrestle with is not whether or not earnings will be challenged, but if it will matter for corporate spreads or if it’s “priced in here.” Currently, U.S. assets even at multi-low-yield levels are some of the most attractive yields to be had on the planet. Even after accounting for currency hedging costs, U.S. corporates offer a significant yield advantage for Asian investors, and we continue to see inflows into our market from those market participants. The U.S. corporate bond market is currently enjoying very supportive supply-demand dynamics and fundamentals aren’t yet poor enough to have caused concern. Although, we do suggest the market cycle peaked in the third quarter of last year.
So the question we are frequently getting from investors is, after such a strong rally and with yields currently as low as they’ve been in several years and potentially going lower with expected central bank rate cuts: Where are the opportunities for us to generate return in the corporate bond portfolios?
Valuations are relatively uncompelling with the Bloomberg Barclay’s Credit Index, and the High-Yield Index is yielding just around 3% and just under 6% respectively. While spreads are not at all-time tights, and to be sure one could definitely make the case that there is room for additional spread compression here in the aggregate, we at MetLife Investment Management prefer to focus on driving alpha from idiosyncratic sources.
The widespread hatred of triple B risk from investors has created ample opportunity for credit pickers to pick the issuers that have been strewn aside with the weakest issuers in that cohort. There are select credits that are actively leveraging, focused on the balance sheet, and have both the willingness and ability to do right by creditors. We also continue to find inefficiencies in bank capital structures in the wake of ever-changing evolution from regulators and ratings agencies.
Lastly, we’re very comfortable to continue to make sales of high-grade credit and simply own Treasuries in the portfolio to maintain liquidity until we find better candidates combined with better valuations to add into the portfolio.