Corporate bonds have become more attractive than stocks

Compared to other major stock market declines, the widening of high yield spreads has been fairly modest.

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By David Rosenberg and Brendan Livingstone

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The stock market has fallen sharply, with the S&P 500 down just under 24 percent from its highs. This move came as the US Federal Reserve opted for a much more aggressive tightening path, reducing the odds of a “soft landing” which was wishful thinking to begin with.

However, unlike other major stock market declines, the widening of high yield spreads has been fairly muted by comparison. Indeed though high yield spreads have widened 215 basis points from lows to just over 510 basis points. Based solely on the stock market decline, we would have expected high yield spreads to have widened by 365 basis points, based on the premise of the traditional relationship between the two asset classes.

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In our view, there are a few key reasons why this has not happened. First, the entire equity market decline, thus far, has been driven by multiple compression rather than deteriorating earnings expectations, the latter being more important for bonds given the implications for debt service. Second, the “maturity wall” was removed as companies took advantage of the low rates of the last two years and refinanced bonds that were maturing soon.

Third, the quality of high yield has improved (for example, the share of BB-rated loans has risen from 35% in 2000 to 54%) and we are emerging from a cycle of default that wiped out some of the weaker names. . in the high-performance universe. Finally, the energy sector, which is overrepresented in high yield (relative to the stock market), has gone from being a major headwind in recent years to being a tailwind.

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That said, while each of these factors may help explain why high yield spreads have not widened as much as might be expected given the stock market crash, we continue to believe that spreads are likely to widen further a as recessionary pressures intensify.

Since peaking in early January, the S&P 500 P/E, based on 2022 earnings, has fallen to 16x from 21.8x. This multiple compression of nearly six points explains the entirety (and then some) of the stock market’s decline. During this period, earnings expectations for 2022 increased from $220 per share to $229 per share.

We continue to believe that the consensus is overestimating the likely earnings profile and therefore downward revisions are likely in the coming months and quarters, but this expectation of rising corporate earnings (by investors) it’s a big reason why high-yield spreads have narrowed. remained relatively tight.

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After all, cash flows are what ultimately matters for debt service. As such, until we see a significant decline in earnings expectations, default rates are likely to be viewed as relatively low, which suppresses potential spread widening.

High-yield bond issuers took advantage of the cheap financing available during the pandemic and refinanced their debt at extremely low rates, extending the maturity profile of their outstanding bonds.

Only seven percent of its outstanding debt is due at the end of 2024, and the peak isn’t until 2029. By contrast, at the end of 2008, 18 percent of outstanding debt was due in the next three years, according to a JPMorgan Chase & Co. analysis So while growth is slowing sharply, which will hurt earnings, having too little debt to refinance anytime soon is a positive dynamic for default prospects.

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But bonuses are only part of the story. Companies also have loans on their balance sheets, which will need to be refinanced at much higher rates when they come due. That could put funding stress on vulnerable companies, weighing on the broader high-yield market. Although the high yield market has held up relatively well, we recommend a sustained focus on better quality credits across the spectrum.

The composition of companies issuing high-yield bonds has also improved over time. The proportion of BB-rated bonds outstanding (the highest tranche in the high-yield market) has increased from 35% in 2000 to 54 percent. As such, there is a favorable quality bias, suggesting that the probabilities of default need to be reduced. accordingly to reflect superior solvency (relative to the high yield market in the past).

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Also, companies that remain part of the junk bond market are perhaps less vulnerable to an economic shock compared to previous recessionary episodes. After all, we’ve only just emerged from a significant default cycle: The default rate peaked at 6.3 percent in October 2020, eliminating many of the weaker corporations from the high-yield investable universe. As a result, the names that remain generally have stronger balance sheets.

Finally, the rise in oil prices over the last two years means that the outlook for energy companies, in terms of prospective cash flows, has improved significantly. High yield spreads, unsurprisingly, reflect this reality. The average ex-high yield energy option-adjusted spread (OAS) currently stands at 522 basis points compared to the high yield energy average of 416 basis points. This 106 basis point discount represents a significant change from the last 10 years when energy traded, on average, at a 174 basis point premium. With a 13 percent weighting to the high yield market, this swing means the overall high yield market is trading 23 basis points tighter than it would otherwise be.

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Each of the aforementioned forces has played a role in limiting the degree of spread widening, but we think the increasing recessionary odds will ultimately win out in the near term. As a result, our base case is for spreads to widen further (likely to 700 basis points), meaning investors should have an investment grade bias (focus on AAA and AA ratings over A and AA ratings). BBB) instead of high yield (hiding in BB over B and CCC). However, if we do get a material widening of spreads, there could be huge opportunities for tactical investors as good credits are wasted with bathwater.

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The main premise here is that there are several structural factors that have made, and probably will continue to make, corporate credit in general a more attractive (perhaps less unpleasant) asset class compared to equities. We expect the outperformance of debt relative to equity to be sustained, but also caution that spreads have yet to widen. It may be better to hedge your corporate credit exposure with a handful of Treasury notes and bonds.

David Rosenberg is founder of the independent research firm Rosenberg Research & Associates Inc. Brendan Livingstone is a senior economist and strategist there. You can sign up for a one-month free trial at Rosenberg’s website.


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