Ben Bennett Market View
As investment-grade yields contract in line with the burgeoning economic recovery, investors are faced with a choice of accepting the lower income on offer or switching into riskier assets to try to maintain returns.
The fact that short-dated interest rates are so low should mean that investment-grade yields remain an attractive, relatively low-risk alternative to keeping money on deposit.
However, it appears that greed is back and investors have become used to the higher risks and higher returns that have dominated 2009.
At the start of 2009, sub-investment-grade bonds and subordinated bank securities, two of the riskiest assets within the credit universe, were very much unloved, with investors scared of near-term default risk, leading to swathes of selling and a collapse in prices. Fast-forward one year and the main consideration now appears to be the yield on offer.
The last few weeks have witnessed volatility in both equity markets and investment-grade corporate bond yields but returns in these higher-yielding parts of the credit market have continued to march steadily higher as investors look for high yield in an environment of ultra-low rates. Is such a rally fundamentally justified?
In recent months, the economic backdrop has improved and blanket corporate bankruptcies and a banking meltdown appear to have been avoided but we are not completely out of the woods yet.
Corporate bond yields, particularly at the riskier end of the spectrum, were attractive at the start of 2009 but the recent dash for trash has pushed valuations to a level that provides little buffer against a further economic setback. If things take a turn for the worse in 2010, demand for high- yielding assets could dry up as quickly as it appeared.
That said, looking at the very near term, there are some important events that could prove supportive for corporate credit risk. Very soon, corporate default rates will have peaked and will steadily decline. They will be coming from a very high level but this topping out will at least provide some welcome visibility of the current credit cycle. In addition, the monthly net change in US jobs may improve to zero around the turn of the year. Again, this does not sound like much to get excited about but heavy job losses this year have represented a potential catastrophe for a wide variety of asset classes such as credit cards, mortgages, and any company linked to consumer expenditure (car manufacturers, retailers, etc).
In addition to these events, we also do not expect the liquidity taps to be turned off for some time to come. Momentum behind the high- yield part of the credit universe may peter out and even reverse at some point in 2010 but for now the current backdrop of low interest rates and easy liquidity should allow companies to obtain financing and investors to hunt for yield.
Interestingly, one area that yield-hungry credit investors may be ignoring is the equity market.
The difference between corporate bond yields and dividend yields is reaching historically low levels. Moreover, it is easy to find specific names where the dividend yield is actually higher than the corporate bond yield. In a very low growth environment, it is possible to argue that dividend yields should be higher, given the higher volatility of equities versus corporate bonds. But if the recovery gathers pace in 2010, dividend yields will look very attractive versus corporate bond yields given the potential increase in equity valuations.
Returning to the dash for trash within the credit universe, we have to hope that this yield grab will gently moderate in 2010 as valuations reach fair value and as governments signal the end to free money.
This may, of course, prove to be wishful thinking as the unprecedented nature of current intervention requires quite a bit of guesswork. The dash for trash may continue for now but investors should try to avoid being the last buyer before the liquidity taps are turned off.
Ben Bennett is credit strategist at Legal & General Investment Management