Breaking down the U.S. corporate bond market

When analyzing the corporate bond market, senior portfolio manager Andrew Kronschnabel focuses on three main factors: the valuation, the fundamentals, and the technical, or supply and demand.

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During a late-October interview, he said valuations were high, with yields of U.S. investment-grade corporates rising above 4% and those of high-yield corporates topping 7%, and even a two-year U.S. treasury yielding 2.85%.

Over the last month, yields have remained elevated. As of Nov. 26, the U.S. 10-year Treasury yield was just above 3%, while the U.S. two-year Treasury yield was around 2.8%. Both were much lower a year ago at approximately 2.3% and 1.7%, respectively.

“You don’t have to look too far back—maybe just a year to 18-months—[to see] when those yields were unheard of without taking extra credit or extreme duration risk,” said Kronschnabel, who works at Logan Circle Partners, a MetLife affiliate in Philadelphia, and co-manages the Renaissance U.S. Dollar Corporate Bond Fund. “As a result of a rising interest-rate environment in the U.S., fixed income is investable again.”

Yet, American bond experts are becoming concerned about a potential corporate debt bubble that’s being driven, in part, by investor demand in the U.S. The high-yield sector in particular is being tagged as overvalued.

For Kronschnabel, assessing fixed income performance and identifying opportunities starts with breaking down economic fundamentals—in the U.S. and internationally. In late October, he said overall U.S. fundamentals were “quite strong,” with employment up and corporate earnings remaining “very healthy.” As well, business and consumer confidence, and manufacturing were “at their all-time highs.”

Still, he also pointed to declining auto sales and dipping housing activity in the U.S., the latter of which experts say is the result of rising interest rates and mortgage rate hikes in 2019.

Further, there were “typical late-cycle types of concerns,” such as the global impact of U.S. dollar strength. A strong greenback significantly affects emerging markets, he said, but it has also weighed on “really all foreign economies.”

Trade rhetoric around tariffs, a concern at the corporate level and for the U.S. economy, as well as Brexit and Italy’s budget were other international factors, he said.

When looking at U.S. fixed income and corporate bonds in the current environment, Kronschnabel was optimistic but cautious. As of late October, he said, “If we drill from the broad economy into the corporate level, […] earnings remain very strong. However, they have probably peaked in recent quarters. We do expect to see those growth rates come down.”

Kronschnabel doesn’t expect negative growth in the near term, and added that growth rates should “remain quite healthy.”

In mid-November, Moody’s Investors Service warned that as the pace of corporate earnings growth slows in the U.S., company credit ratings could slide, leading to higher risk. This is occurring at the same time as investors are turning to companies with slower, steadier growth.

Bond ratings and risk

The growth of triple B-rated bonds is one reason experts are saying corporate bond markets are getting riskier.

“That’s been the source of a lot of concern,” said Kronschnabel. “In the last eight years, the U.S. high-grade corporate fixed income market has approximately doubled in size,” he said, with the triple-B component growing to about half of the overall market.

These types of bonds carry more credit risk than higher-quality A to triple A-rated bonds.

Kronschnabel suggests looking at the main drivers of triple B-rated bond growth before writing them off, however. One is increased M&A activity in the U.S., with high-profile deals such as CVS-Aetna, Bayer-Monsanto, Amazon-Whole Foods, AT&T-Time Warners, Disney-Fox and Comcast-Sky.

“A lot of the supply that has crept into the triple-B cohort of the U.S. investment-grade market has been from this,” he said, due to resulting debt from the transactions.

One reason he’s not yet concerned about the corporate market is “this isn’t like the triple-B company of 10 years ago. These are very large companies with lots of levers and lots of ability to reduce their debt as they move forward and integrate in these transactions.”

Still, some companies are suffering. For example, one “high-profile downgrade from the single-A cohort was Anheuser-Busch InBev, as they refused to pay the debit associated with [their October 2016] SAB Miller transaction.”

That’s why active managers must be vigilant, Kronschnabel said. To add value, you need to “avoid those over-levered M&A issuers and the [corporate bond] downgrades that are likely to happen.”

Still, triple-B bonds outperformed single-As “quite handily” in the first three quarters of this year, he said.

M&A activity, which has driven a lot of the supply, is declining rapidly as interest rates rise, Kronschnabel said. Also, big tech and pharmaceutical companies repatriated their debt after changes to U.S. corporate tax structure and no longer have reason to issue debt, he said.

“So we’ve seen the huge sources of supply over the last several years are starting to dissipate and we’ve had lower issuance overall in 2018,” he said. “We expect that to continue in the fourth quarter of 2018 and into 2019.”

Demand continues from overseas buyers for U.S. fixed income, he said, and it’s started to come from  retail investors, too. The latter trend is tied to demographics, he added, given “one of the biggest flows that will be seen over the next few years is this retail or individual investor reducing their exposure to stocks and increasing it to fixed income.”

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