The rally in corporate bonds this year is reminiscent of Usain Bolt in full flight in the 100m dash at the Beijing Olympics. Historic. Unprecedented. Fast. So just how far have corporate bond spreads rallied?
After blowing out late 2008 and early 2009, corporate bonds spreads have rallied back to levels that were last seen before the Lehman Brothers collapse. And rightly so. Corporate bond spreads were pricing in a very pessimistic level of defaults, especially for investment grade corporates. If we believed what corporate bond markets were telling us, we should have been building shelters and waiting for the collapse of the world as we know it.
Fortunately this scenario didn’t eventuate. We have discussed the factors surrounding this rally here, and I have updated a couple of charts that we used back in May. Looking at BBB spreads, the current level of spreads suggests that the economic environment for corporate bonds is now a “typical” recession. From this, we can extract that the market is now expecting an increase in the level of defaults that is consistent with that experienced during a typical recession (the worst experienced default rate in Europe was 5.8% for BBB bonds over 5 years). Industrial spreads have rallied to such an extent they are now lower than the peaks seen back in 2002.
What is really interesting is the total (capital appreciation plus interest) returns that the various indices have generated for investors. Nick Burns from Deutsche Bank notes that from a starting point of July 31 2007 – a time when credit spreads were very low – BBB corporate bonds have returned close to 13% in Europe, 10% in the US and 4% in the UK. Corporate bond returns are now only slightly lagging government bond returns over this period. This is impressive considering that if an investor sold at the peak of credit spreads (let’s say around December 2008), he or she would be looking at a loss of -9% in the US, -6% in Europe and -15% in the UK. Over the same period, equities have not performed quite so well. Since end July 2007, the DJ Stoxx 600 is -36% lower and the S&P 500 has fallen by -29%. Basically, the financial crisis has had negligible impact on an investor’s IG corporate bond portfolio. This is amazing given the heart attack financial markets had last year.
Importantly, the good returns in corporate bond markets reflect the fact that credit markets are healing and are returning to normality. The first half of 2009 has seen a record amount of new corporate bond issuance by non-financial companies. Investors’ risk appetite is increasing and there has been a lot of demand for these new issues. The cash holdings that were hoarded by investors following the financial crisis are now being put back to work and IG credit continues to look cheap relative to forecasts for future economic growth.
It is clear that corporate bonds have been the star performer in financial markets this year. We continue to believe that credit spreads are overcompensating for the risk of default, but it is almost impossible for corporate bonds to continue rallying at this 100m pace for more than another three months on credit spread tightening alone – if they do, then credit spreads will be at all time record lows.