Volatility
Volatility in default swaps and bond spreads has collapsed and the spreads themselves are at near historical lows. Flows into corporate bond funds have been unremitting, while systematic traders are “max long the asset class,” according to UBS Group AG. In the Australian context, oversubscription in corporate bond issuance has been at record levels reflecting demand and supply dynamics of income-oriented investments.
Total Return Assumptions
Instead of spreads, these investors appear to be focused on the attractive coupons, or interest income, that corporate credit currently offers. One implication of this investor behaviour is that even market-moving events like US President Donald Trump’s tariff threats and the potential for fewer interest-rate cuts by central banks haven’t managed to knock credit markets down. It seems investors have taken the view that a high level of all-in yields, and current buffer against possible spread widening, will adequately protect their portfolio.
Fundamentals
Importantly, this view appears to be in the context of fundamentals remaining healthy and supported by technical support. For instance, issuer leverage (indicator of credit risk) has come down over the past five years across domestic and offshore credit markets. Additionally, while interest coverage ratio (indicator of debt serviceability risk) has also fallen as a result of higher rates, it remains at a healthy absolute level. Earnings growth has also been solid, and particularly in the US (ala, current 4Q earnings season).
Valuation
But with credit spreads so tight, corporate bonds are undoubtedly expensive and are so across the credit quality spectrum. While there is a general complacency in the markets regarding spreads currently, it is often when complacency is high that everything is not. To be clear, policy uncertainty and the chances of a policy mistake in multiple jurisdictions is very high at present.
Forward Risks
The real point here is the following. Corporate bond markets are currently positioned in a manner that translates to high event risk. Markets seem now more vulnerable to negative surprises and event risks which could magnify asset price risks particularly of lower grade credit. What may have been a, for instance, 8% coupon based return becomes a 3% total return for the year as capital losses from possible credit spread blow-outs take toll on total returns.