The difference between yields on corporate bonds and less risky government debt continues to narrow, suggesting that share-price declines aren’t because of widespread fears about the financial health of the world’s companies.
Previous U.S. equity market corrections, since the 2008 credit crisis, have been matched by big moves in corporate-credit spreads, as investors sought a higher premium over government bonds to compensate for their increased concerns over corporate health.
Currently, that isn’t the case. On Friday, as the Dow Jones Industrial Average recorded its deepest selloff since the Brexit vote in June 2016, spreads on dollar and euro-denominated corporate credit ticked down to their lowest levels since 2007, indicating that bond buyers don’t currently require a greater payoff against the risk that such debt defaults.
For example, while Apple Inc.’s stock is now down about 4% year to date, spreads on the company’s 2029 bonds have dropped from 0.80 percentage point to 0.66 percentage point.
U.S. corporate bonds offered yields just 1.08 percentage points more than government bonds of the same maturity Friday, according to IHS Markit ’s iBoxx indexes. The spread on European corporate bonds was even lower, at just 0.82 percentage point.
On Monday, European, Asian stocks and U.S. shares were falling again. The Stoxx Europe 600 was down 1.6%, the largest drop in a year and a half, Japan’s Nikkei 225 dropped by 2.5% and the S&P 500 fell 4.1%. The spread on European corporate bonds barely budged to 0.83 percentage point.
“I think the resilience of credit to the most recent selloff within equity should provide equity investors with a little bit of comfort,” said David Riley, head of credit strategy at BlueBay Asset Management.
“It suggests credit investors still feel very comfortable with corporate credit fundamentals, the earnings outlook and the ability of the corporate sector to absorb higher rates,” he added.
During previous market turns like the nearly 14% drop of the S&P 500 in February 2016 from its May 2015 high, the spread on the iBoxx U.S. corporate index rose by nearly 0.9 of a percentage point.
Similarly, during the height of the European sovereign-debt crisis in 2011, when the S&P 500 fell 18%, corporate spreads rose by 1.7 percentage points.
To be sure, those share-price declines were far larger than the drawdown in global equities over the past week. But so far, there is little indication that the selloffs are based on expectations of significantly deteriorating economic conditions and company profits are mostly beating expectations. With roughly half of S&P 500 companies having reported fourth-quarter earnings so far, 78% have beat analyst expectations, compared with 64% in a typical quarter, according to Thomson Reuters data.
“Really, there is no recessionary risk out there that’s telling you not to invest in bonds paid for by the cash flow of companies,” said Ewan McAlpine, senior client portfolio manager at Royal London Asset Management.
Data on Monday continued to point to an acceleration in global growth that should be supportive for both stocks and credit. The IHS Markit eurozone January purchasing managers index reached its highest level since June 2006, while the U.S. Institute for Supply Management’s nonmanufacturing PMI rose to 59.9, well above the 56.5 expected.
The credit market “is a supportive factor in my view that I don’t think we’ve hit the turn in the equity markets,” said Dave Lafferty, chief market strategist at Natixis Investment Managers.
why are stocks falling?
The difference between the two asset classes this week may in part reflect stocks’ more exuberant start to the year. Equity markets drew record inflows and the S&P 500 rose 5.6% in January, its biggest monthly gain since March 2016. Since the beginning of the year credit spreads on both the euro and dollar iBoxx corporate indexes have declined by roughly 0.1 percentage point.
“All of the discussion at the moment that is negative about the equity market, none of it is about the economics, it’s all about those valuations and ratios,” Mr. McAlpine said.
Investors have been debating whether U.S. stocks look expensive, and what valuation should be used to measure that. The S&P 500’s 12-month rolling price to earnings ratio, a popular valuation measure, reached 23.4 in January, its highest level since 2002.
But not everyone believes that the message from corporate debt markets is the correct one.
On Monday, S&P Global Ratings warned that the global proportion of highly leveraged companies, with a debt to earnings ratio above five to one, has risen by 5 percentage points since 2007, to 37%.
Higher debt levels leave companies vulnerable to unexpected fast increases in interest rates, which would make it more costly to pay off their debt.
“When you are seeing this type of volatility it does raise the question of whether credit spreads should be trading near all-time tights,” said Sunil Krishnan, head of multi-assets funds at Aviva Investors. “I don’t think you’re getting very good compensation for volatility.” - WSJ
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