Capture alpha in corporate credit

Following the rally in risk assets this year along with corresponding low yields, fixed income investors might be pondering where the next opportunity in corporate bonds will be — especially considering yields could fall further as central banks potentially cut interest rates.

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In a July 24 interview, Andrew Kronschnabel, head of investment grade credit at MetLife Investment Management in Philadelphia, provided context for the risk rally.

Before the Fed’s initial dovish pivot on Jan. 4 when Fed chair Jerome Powell said the central bank could be patient in the face of muted inflation, corporate spreads were at their lowest levels over one year, Kronschnabel noted. For example, investment grade and high yield credit spreads were about 150 and 550 basis points, respectively.

Subsequent dovish communication from the Fed helped investment grade spreads rally nearly 50 basis points by the time Kronschnabel was interviewed, generating “over 400 basis points of total return relative to Treasurys and 10% total return absolute,” he said.

Over the same period, U.S. high yield spreads rallied nearly 120 basis points, returning “over 6% better than U.S. Treasurys and nearly 10.25% total return,” he said.

The rally occurred despite declining fundamentals in the corporate market, as well as increased friction and uncertainty related to trade tariffs, he said. In the second half of the year, these could prove more challenging for corporate earnings.

While an accommodative Fed, which cut its key interest rate for the first time in a decade by 25 basis points on July 31, helped drive financial assets and commodities to impressive levels, the central bank can’t print corporate earnings, said Kronschnabel, who co-manages the Renaissance U.S. Dollar Corporate Bond Fund. “That’s where we are laser-focused right now.”

Corporate earnings growth was about 25% in the second and third quarters of 2018 on the back of the U.S. corporate tax cut. As a result, “Those are very difficult base effects to compare against, and we are concerned that earnings growth in upcoming quarters will struggle to be positive,” he said.

Companies face the added challenges of U.S. dollar strength, increasing costs for wages and ongoing trade uncertainty. The key question is whether lower earnings growth will affect corporate spreads or if it’s already priced in, he said.

As it stands, U.S. assets, even at multi-low-yield levels, are some of the most attractive yields globally, he said. For example, “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,” Kronschnabel said.

Yet, he also noted that valuations aren’t compelling, with the Bloomberg Barclays credit index and ICE Data Services high yield indexes yielding just under 3% and 6%, respectively. While spreads aren’t at all-time tights, Kronschnabel said the firm prefers to focus on driving alpha from idiosyncratic sources.

Triple B is an example.

“The widespread hatred of Triple B risk from investors has created ample opportunity” to pick issuers strewn aside with the weakest of that cohort, he said. Select credits are deleveraging their balance sheets and have both “the willingness and ability to do right by creditors.”

He said his firm also continues to find inefficiencies in bank capital structures amid the “ever-changing evolution from regulators and ratings agencies.”

Lastly, Kronschnabel said he’s “very comfortable” continuing to sell high grade credit and own Treasurys. Such a move maintains liquidity “until we find better candidates, combined with better valuations, to add into the portfolio,” he said.

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