Corporate Bond Commentary and Strategy
August 2009
By Brian Pollak
Vice President & Fixed Income Portfolio Manager
Spreads will continue their march toward normalization—but not in a straight line. We are taking advantage of tightening spreads while guarding against idiosyncratic credit risks and longer-term inflation.
The corporate bond market's positive returns since March 2009 have been historic by any measure. An investment made on March 31 in the Barclays Capital Credit Index gained a truly remarkable 12.72% as of July 31, which more than offset the index's 2008 negative return of 3.08%. Spreads over Treasuries have come back from towering levels—they were more than double the previous bear market highs set in 2002—and have normalized but are still indicative of a cyclical bear market for credit.
In this environment, we must continue to be selective in taking credit risk and must manage duration and maturity profiles carefully.
Positioning our portfolio
Corporate bonds remain attractive relative to many other fixed income asset classes—as spreads remain historically wide—but we no longer see investment grade and BB-rated corporate bonds as being viable stock substitutes.
During the first half of 2009, we could capture a yield to maturity of 8%-12% with a basket of these securities, which we viewed as attractive in an uncertain marketplace. While we continue to see opportunities in BBB and BB credits, where yields appear attractive relative to the risks, these securities no longer appear attractive relative to historic equity returns.
We remain comfortable with the corporate bonds we have purchased in client portfolios. But in portfolios with no excess cash and higher yielding corporate bond positions, we plan to sell bonds to raise cash for our best new equity investment ideas.
For core taxable fixed income portfolios, we recommend selectively purchasing higher quality credit with final maturities of as much as six to ten years in order to take advantage of the steep Treasury curve. Also, we still see opportunities for yield in well researched BBB industrial and higher-quality financial services issues, as both of these sectors remain somewhat dislocated relative to historical spread levels.
Over time, spreads will continue their march toward a path of normalization but it will not be a straight line. Our focus is on investing in a way that takes advantage of spread tightening trends while guarding against idiosyncratic credit risks and longer-term inflation.
Understanding recent historic spreads
What forces have been at work over the last 10 months? It seemed the world was ending in November 2008, when the Barclays Credit Index was more than 500 basis points over comparable Treasuries. There was no confidence in even the strongest financial institutions and there were concerns that even the highest quality industrial companies would not be able to refinance near-term debt or roll commercial paper. Even money market funds were considered a risky investment. Worse yet, the market had little faith that the government could stem the tide of economic disaster.
In this environment, spreads for investment grade corporate debt deserved to trade with a risk premium far outstripping any risk premium the asset class had seen since the Great Depression. The system was truly at risk and remained so through March of 2009.
Today, less than one year since Lehman Brothers failed and approximately four months since the S&P 500 bottomed in the mid-600s, we no longer worry about the solvency of the largest financial institutions. Money market funds are no longer in danger of "breaking the buck" and industrial stalwarts, like IBM, have no problem rolling over commercial paper.
The government stepped in with an array of programs, both fiscal and monetary, that have provided confidence to the market. This confidence led first to high quality corporate debt issuance, then to issuance of lower rated corporate debt, equity, convertible bonds, and even some securitized debt. Liquidity returned to the markets and the risk of system-wide failure has receded into memory.
The violent narrowing of spreads correctly reflects this but risks still abound. Corporate default rates continue to rise and will remain elevated; many companies will continue to migrate from investment grade to speculative grade; inflation remains a risk in the medium to longer term; and how the Federal Reserve will manage the monetary base is a looming question. Managing these risks appropriately will be paramount to future outperformance.
Brian Pollak joined Evercore Wealth Management in February 2009 as a taxable bond portfolio manager. He can be contacted at brian.pollak@evercore.com
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Disclaimer: Any opinions quoted are for information only and do not constitute investment advice or recommendation to any reader to buy or sell investments.