What's going on in North American corporate debt markets looks like sheer lunacy to me and there are few, if any, corporate debt issues I'd go anywhere near with yields where they are.
The majority of the investment upside in the sector simply has to be behind us, yet the feeding frenzy on newly-issued corporate bonds continues.
There are three ways corporate bonds can increase in price – lower general interest rates, tighter credit spreads and credit rating upgrades. All of these sources of returns appear to be tapped out.
In the first case, the smartest of the smart money is banking on higher, not lower interest rates. The Eurodollar market, where the world's largest banks place their bets on future rates, indicates that by March 2016, the three-month LIBOR interbank rate – a key overnight rate affecting global lending costs – will climb from the current 0.23 per cent to 1.25 per cent.
A 100 basis point increase in three month rates means at least a 1.0 per cent rise in five and ten year U.S. Treasury yields, probably a lot more given the usual shape of the yield curve. Corporate debt is priced using Treasuries as a baseline, so the bonds being bought now will trade at higher yields and significantly lower prices.
Corporate bonds also rise in price if spreads tighten – the yields fall closer to government bond yields. But this is highly unlikely in the years ahead. The average BBB spread to Treasuries is 168 basis points, not far off from the pre-crisis levels of 125 bps that, in hindsight, are considered delusionally low.
In addition, there is even less potential upside in more recent deals. CNA Financial Corp recently issued $550-million (U.S.) BBB-rated bonds with a spread 70 basis points lower than the 168 basis point BBB average.
The chart below shows the effects of spreads on future performance in the corporate bond sector. As spreads decline, so does future performance. At current levels, the trend line indicates a total return on BBB rated corporate bonds at a meagre five per cent in the next twelve months.
For equity investors, higher corporate borrowing rates will also have negative effects on returns. The practise of borrowing in bond markets and using the proceeds to buy back shares has been behind profit growth for a large number of U.S. companies. Higher rates will make this less common.
Credit ratings are specific to each issuing company so it's hard to generalize about the prospects for upgrades. But if rates do start to move higher, it would place more stress on corporate balance sheets and over all, there will likely be fewer credit upgrades in the future.
It is true that the rate of defaults on corporate debt remains low. Investors in recently-issued corporate bonds are likely to get their money back and all the coupon payments made.
But, they are locking in to low annual returns – usually between three and four per cent – with very little chance of upside. Eurodollar trading strongly suggests that, in the coming years, government bonds will offer higher yields than currently available in higher-risk corporates. Investors in recent corporate bond issues will have the choice of underperforming, or selling bonds at prices well below the $100 face value.
It's easy to see why companies are issuing more and more debt – it's pretty much free money for them to play with. The real question is why investors are climbing over each other to buy expensive investments with such a high probability of underperformance or losses.
Scott Barlow