Corporate Bond Commentary
and Strategy
December 2009
By Brian Pollak
Vice President & Fixed Income Portfolio Manager
Yields on investment-grade credit securities are approaching historic low levels. At the end of November, the Barclays Capital Credit Index stood at about 4.25%. Just one year ago at the height of the credit crisis, this same index was close to 8%. Over the same period, the spread between investment-grade credit indexes and US government Treasury notes and bonds plunged from over 550 bps to under 190 bps. Though that’s well above the longer-term historical average of about 120 bps over Treasuries, in almost any context such moves would be astonishing.
Large corporations have generally been able to re-finance existing debt and raise new capital at attractive levels, while at the same time aggressively cutting costs. Balance sheets are defensively positioned overall, with significant cash on hand, limited near-term debt maturities, and good overall liquidity profiles. Technical factors are supportive as well. In 2009, net and gross corporate bond issuance hit new records. We expect issuance to decline significantly in 2010 as refinancing needs have lessened. This could also further reduce spreads, as institutional investors still have abundant cash on the sidelines. Thus, despite some continued idiosyncratic risk and volatility, we believe there is still potential for further tightening even after the recent improvement in credit spreads.
At the same time, Treasury yields are low, and the curve remains steep. The bond market is focused on the timing and magnitude of the Federal Reserve’s next rate hike. The Fed must wrestle with difficult decisions, and the window for getting policy exactly right is narrow. Holding interest rates low for too long or raising them too slowly risks letting inflation spiral out of control. Raising rates too early or too quickly risks pushing the economy’s growth back to sub-normal levels. The same delicate balance applies to the Fed’s Quantitative Easing program. When does the Fed stop purchasing and when does it sell the $1.75 trillion of MBS, Treasury and Agency securities that have swollen its balance sheet by more than 100%? The decisions could drastically affect both the capital markets and the economy at large in 2010.
For the bond market, the tug-of-war lies between strong balance sheets and improving corporate credit quality on one side, and the potential pitfalls of unprecedented monetary policy on the other. We believe investors must take both forces into account, and we try to accomplish this by keeping portfolios laddered, but with a shorter than benchmark duration. By buying shorter duration bonds where credit spread makes up a large portion of the overall yield, we mitigate the risks of a rise in short-term rates somewhat. But credit selection still matters, so continued diligence in picking securities with attractive yields given their ratings and operating profiles remains of utmost importance.
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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