Thomas Chow, Chief Investment Officer — Corporate Credit
William Stitzer, Assistant Portfolio Manager
Investment grade bond issuance has spiked recently, with the first week of March posting the second-largest weekly supply on record (behind only the $65 billion week in September 2013, which included the record-breaking deal completed by Verizon Communications).
Despite this recent flood of new supply, we believe the technical backdrop for credit markets remains positive for a number of reasons, including:
- Supply forecasts for 2014 are down from the record issuance of 2013, which came in at roughly $850 billion. Some issuance has likely been pulled forward due to benign market conditions, but there are still wildcards that could influence supply levels in the coming year. Among them: interest rates, M&A activity, share buybacks, and financial supply.
- Investment grade markets have been a relative safe haven from global volatility, particularly the recent turmoil in emerging markets.
- Interest rates remain low on a historical basis, and with yields on 10-year U.S. Treasurys recently close to eight-month lows, conditions are currently favorable for issuers. The downside has been an increase in shareholder-friendly use of proceeds to the disadvantage of bondholders.
- Credit metrics within the investment grade sector remain satisfactory. Revenue, EBITDA1, net leverage, and other metrics have shown improvement recently. What's more, financial services companies have recovered from the financial crisis with much stronger balance sheets and defaults remain at historic lows.
- Demand for long-duration bonds is steady, driven in part by improvements in pension plans' funding status, which has motivated them to lock in gains by switching from equities to fixed income.
- Traditional asset/liability management buyers such as insurance companies are expected to continue to drive demand for long dated assets, especially if rates rise.
- Global financial institutions are transitioning from government debt (sometimes referred to as sovereign debt, especially in international markets) toward corporate allocations.
- While absolute annual returns will be predicated on interest rate moves, investment grade corporate bonds offer a measure of diversification when complemented by other investment grade alternatives.
Data noted above are based on materials published by sources that include: Moody's; Barclays; Federal Reserve Bank of St. Louis; and Dealogic (via Dow Jones).
A few words about risk
It's important to understand that despite numerous headwinds, the U.S. economy is showing signs of steady — albeit slow — progress. With that in mind, we believe that when it comes to risks, the bigger challenge is related to mark-to-market risk, certainly more so than fundamental risk (at least in the intermediate term).2
To help explain what we mean: We believe that in the coming months, risk appetites will be influenced by factors such as rising shareholder activism and rising M&A activity. Other determinants of risk tolerance could likely include: (1) China's growth prospects and the consistency of its economic performance, (2) continued economic recovery in Europe, and (3) geopolitical unrest around the world (particularly in emerging markets).
1Earnings before interest, taxes, depreciation, and amortization.
2In other words, if investors experience temporary bouts of anxiety, market prices for financial assets could fall below their actual intrinsic values.
The views expressed represent the managers' assessment of the market environment as of March 2014, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice.
Investing involves risk, including the possible loss of principal.
Fixed income securities and bond funds can lose value, and investors can lose principal, as interest rates rise. They also may be affected by economic conditions that hinder an issuer’s ability to make interest and principal payments on its debt.
Funds that invest in bonds may also be subject to prepayment risk, the risk that the principal of a fixed income security that is held by the Fund may be prepaid prior to maturity, potentially forcing the Fund to reinvest that money at a lower interest rate.
International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.
Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.