Investing in investment grade corporate securities proved quite challenging and for that matter mostly unrewarding last year, as it has for most of the past three years. But that has begun to change. There are clear signs in the US of an environmental improvement that makes the case for investing in corporates compelling. For what has been until recently a simple bet on valuations has now had added to it the appeal of an improving credit story and greater respect shown to the holders of debt.
For those drawn to the corporate sector, the primary driver for allocating investments to corporate securities has been valuation. The meaningful underperformance of the sector last year pushed yield spreads to historically wide levels relative to Treasury securities, as well as other spread sectors. Indeed, the widening of spreads incorporated many of the negatives that caused many market participants to dislike these debt securities, and yet they eventually became too cheap to underweight. The negatives, however, remained: the pre-eminence of shareholders, as opposed to debt-holders, in the minds of corporate management; competitive, technological and business model obsolescence risks; long-term debt financing of risky projects; increased leverage; and a softening economy.
The passage of time, though, can work wonders. The normal path of a credit cycle and market forces that are acting to focus issuers on debt-holders’ interests are combining to mitigate, if not improve, many of these risk factors, adding a fundamental credit story to valuation arguments for owning corporate securities. Perhaps somewhat ironically, slower economic growth can set the stage for improving credit fundamentals. To the extent that slower growth means a diminished pace in capital investment, the need to borrow is reduced and corporate cash flow improves. In essence, while it has its idiosyncrasies, the current credit cycle is following historical patterns.
As is typical, through the first half of 2000 late-cycle monetary tightening, higher interest rates, an inverting yield curve, and a weakening stock market led to wider spreads – both swap and asset swapped. More recently, early stage monetary easing, yield curve steepening, and a slowdown in bank balance sheet growth resulted in generalised non-Treasury spread tightening (swap spreads). Corporate securities, at this stage, remain challenged by weak earnings, cash-flow problems and falling equity prices. Finally, a lower interest-rate structure, bottoming economy and a focus on repairing balance sheets (debt-holders’ interests) should lead to an improving credit environment and tighter credit spreads. Indications are that we are moving into this stage. Markets, being forward-looking, should react accordingly.
The idiosyncrasies of this cycle, however, decrease one’s comfort level in following cyclical instincts. Corporations, at the behest of equity investors and as a result of compensation schemes that cause managers to behave like equity investors, have embraced a firm model that holds the interests of equity investors paramount with only slight regard for debt-holders. Balance sheets have been levered. Risky long-term projects have been debt financed. Average credit ratings have moved lower. In addition, a more highly competitive environment and the technological and business model obsolescence risks that characterise present times have amplified this disregard. The value of the put-like feature debt-holders provide equity holders has increased.
Why then, in spite of signs of cyclical improvements, should investors be willing to finance corporations? Because, like better valuation and improving cyclical factors, one can see improvement with respect to the treatment of debt-holders by borrowers.
In essence, debt-holders have begun to stand up for themselves and issuers have been forced to notice. First, spreads have widened and the cost of borrowing has increased for all borrowers. Second, and perhaps more importantly, liquidity has dried up for borrowers who have most mistreated debt-holders. Banks are tightening their credit standards, and the limited buyers of lower quality short-term debt continue their inhospitable treatment of the growing universe of A2/P2-rated issuers. The credit dynamics in bank lending and the short-term capital markets, in particular, are making borrowers aware of the high price one pays for credit degradation – the usurious cost of liquidity or the evaporation thereof.
High yield investors have also necessarily become more selective. Investment grade securities that disappoint are treated more like stock than bonds. If a borrower is classified as distressed, they have nowhere to turn. In general, lenders as a class, while not shutting off credit to all borrowers, have become much more discriminating. Rating agency downgrades are heightening this sensitivity, and borrowers have been forced to pay close attention.
Better indenture covenants, including coupon step-up language in the event of a downgrading, selling assets to pay down debt, and a slowing in stock buybacks are all indications that the concerns of debt-holders are being given a higher priority. Of course this behaviour is not magnanimously driven, and issuers would not behave this way if there were no cost associated with doing otherwise. Still, the pendulum that reflects corporate management’s attention to stockholder versus bondholder interests appears to have reached its apogee.
While it is always difficult to decide to take more risk while environmental deterioration continues to be evident, it is also at those times that one is best rewarded. Given today’s swiftness in market moves, one has to be willing to risk being early in order to catch a change in sentiment. Given the decreased liquidity of even investment grade corporate securities, it is almost a necessity. Though specific risk remains high and diversification and solid fundamental credit analysis are a must, it is time to overweight the corporate sector.
Mark J Wirth is director, fixed income strategy at Northern Trust Global Investments in Chicago