Fixed Income: Credit Sector Report

Sector report by Jenna Xu, 29 January 2021

EXECUTIVE SUMMARY

This report examines the state of credit markets in the US and China by reflecting back on the past events in 2020 and looks at the viability of investing in certain popular ETFs.

Low interest rates have enabled companies to go on a borrowing binge in 2020. There are some unintended side effects to this – US investment-grade bonds are now particularly sensitive to rising Treasury yields, while junk bond investors are benefitting disproportionately. Meanwhile in China, several companies rated at triple-A have defaulted, calling also into question the credibility of domestic credit rating agencies.

In terms of ETFs, the two in focus are the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) and the Vanguard Short-Term Corporate Bond ETF (VCSH). As the largest corporate bond ETF, LQD definitely bears some mentioning. Although it’s not the best time to invest in the bond market right now, VCSH might be worth looking into for investors due to its shorter maturities and low expense ratio.

OVERVIEW OF SECTOR

In response to the pandemic, central banks across the world have cut interest rates to close to zero. This creates a favourable environment for companies to borrow money in the form of issuing bonds – and indeed, 2020 was a year of record issuance, with global bond issuance at $5.4tn. Many governments have also created additional programs to make it easier for companies to take on debt, and in some cases, governments have even introduced programs to buy corporate bonds themselves. We take a closer look at the situation of corporate credit in two of the largest bond markets, the US and China.

United States

Federal Reserve Buys Corporate Bonds

In March 2020, the US Federal Reserve announced an unprecedented move to buy corporate bonds. Two facilities were established –  the Primary Market Corporate Credit Facility (PMCCF) for new bond and loan issuances and the Secondary Market Corporate Credit Facility (SMCCF) to provide liquidity to outstanding corporate bonds. Purchases under the SMCCF included both bonds directly from companies and ETFs.

Between the two initiatives, up to $750b worth of bonds can be bought, with the Fed stipulating that most should be rated as investment-grade, or at least rated as investment-grade before the pandemic. Both facilities stopped buying assets on December 31, 2020, but the Fed intends to continue funding until the assets mature. As of December 2020, the Fed’s portfolio of corporate bonds and ETFs is estimated to be around $14b.

However, the Fed has received some criticism for its bond-buying decisions and has been partially blamed for causing the disconnect between the economy and the stock market earlier in 2020 – when several stocks returned to their pre-pandemic levels but the economy had yet to recover in terms of spending and employment levels. Although the Fed does not release explicit details of the investments and the positions it holds, it has created its own market index from which investment decisions are based off on, known as the Broad Market Index. With the program originally intended as a means to help companies tide through the difficulties and economic shutdowns brought on by the pandemic, the Fed’s possible decision to hold significant positions in cash-rich companies such as Apple and Toyota has raised some eyebrows. In the most recent index published in January 2021, the top six companies – Apple, AT&T, Daimler, Toyota, Volkswagen and Verizon – make up slightly more than 10% of the index.

It’s still unclear at this point if the Fed’s program has actually achieved its intention to cushion the fallout from the pandemic, given the divergence in the state of the stock market and the economy. However, one thing is evident: the mere promise that the Fed was going to start buying corporate debt was enough to benefit companies as is. Corporate bond sales surged in the weeks after the Fed’s announcement, and companies responded by issuing more debt.

In the weeks after the Fed’s announcement (before the Fed had actually begun to buy bonds), Sysco Corp – a large American food service company – sold $4b of debt. Shortly after, it announced plans to cut one-third of its 69,000-strong workforce – more than 20,000 employees – while continuing to pay dividends to its shareholders. While Sysco Corp is certainly not the only company to have done this, it definitely raises questions about the effectiveness of the Fed’s program.

US Investment-Grade Debt Performs Poorly

Bonds are traditionally used as a hedge against the riskier equities – blue-chip bonds, in particular, are seen as a safe way to get modest yield with relatively low volatility. However, investment-grade debt performed poorly last year, with investors losing about 0.9% on average this year through Jan 20, according to a Bloomberg Barclays bond index reported by FactSet. In contrast, high-yield bonds had a return of 0.63% and municipal debt a 0.10%.

Credit spreads have been tight recently, and the US Treasury yield has been increasing sharply over the past few weeks as a result of expectations of inflation and economic recovery. An increase in the US Treasury yield is bad news for bond investors – particularly since the average duration of investment-grade bonds right now is especially high as a result of many companies refinancing their debt in the form of long-term bonds with low yields at the end of 2020.

Unfortunately for bond investors, it seems that the US Treasury yield looks set to increase even further. One of the major factors for this would be the shift of US government control to the Democratic Party, which is expected to result in more stimulus – and this requires more Treasury issuance to fund.

Junk Bonds Set Record Issuance

Meanwhile, US junk bonds started off the year with record issuance. As of January 21, $32b worth of junk bonds have been issued.

Junk bonds have benefitted disproportionally more from the pandemic – with low interest rates, investors searching for more yield have been willing to accept the greater risk that comes from lower-rated bonds. Naturally, companies with poorer credit rating are taking the opportunity to borrow more at a lower cost.

The rally in junk bonds might be set to continue for a while longer. Most central banks are set to maintain their low interest rates throughout 2021 to help the economy recover from the effects of the pandemic. Even if US Treasury yields increase, junk bonds may not be as negatively affected as investment-grade bonds, due to their higher yields and shorter maturities. The size of the credit spread gives greater leeway to absorb changes in the interest rate, meaning investors in junk bonds are usually better off than investment-grade bond investors when interest rates rise.

China

String of Surprising Defaults in the Chinese Market

In late 2020, a string of defaults by prominent state-owned enterprises surprised investors and rattled Chinese markets. Several AAA-rated (the highest rating possible) companies were among the contributors to a new record of US$30b in defaults, a stark increase from the previous record of $21.8b set in 2019 – only the year before.

The reasons for this are manifold: earlier in 2020 in a bid for economic recovery from the pandemic, Beijing introduced a slew of measures which enabled companies to have easy access to credit. Like many companies around the world, Chinese companies went on a borrowing binge. Unlike other investment-grade companies around the world, several Chinese companies have been unable to pay back.

This has exposed an underlying weakness in China’s corporate debt market: the credibility of domestic credit ratings. More than 70% of Chinese corporate and government debt is rated triple-A, meaning that it technically should have a very low chance of default. 96% of onshore credit ratings are the equivalent of investment-grade. Yet in the second half of 2020 alone, 10 state-owned enterprises (with a combined bond balance of over USD $15.7b) either defaulted on or rolled over their bonds. This calls into question the validity of the methodology used to account for credit risk by domestic rating agencies: for state-owned enterprises in particular, ratings are predicated on the assumption that provincial governments would step in to bail out the company.

There have been attempts to reform this by having international rating agencies such as S&P Global issue separate ratings, with limited success. Yet it’s not all doom-and-gloom for Chinese markets. Perhaps the silence of the government may be the most effective reform of all: by allowing the weaker SOEs to fail, it differentiates credit risk across companies in a way that domestic credit agencies have not been able to do and increases overall transparency of the corporate debt market.

Given that China is keen to open its bond market to international investors and China’s total debt-to-GDP ratio (close to 300%) is incredibly high, deleveraging remains a priority as many investors are hesitant to invest in China due to the high leverage. We may expect to see more defaults in the coming months in the light of Beijing’s new stance against highly-leveraged companies – even if they are state-owned.

QUANTITATIVE ANALYSIS

There are two main risks associated with corporate bonds: interest rate risk and credit risk.

Bonds are particularly sensitive to changes in the interest rate. Bonds have an inverse relationship with interest rates: when interest rates rise, bond prices fall and vice versa. This is because a rise in interest rates means that new bonds would be issued with the more attractive rate, hence the prices of existing bonds would have to fall in order to remain competitive with the new issuances. The interest rate risk is determined by its duration – which is not the same as the time to maturity – but generally the longer the time to maturity, the greater the interest rate risk.

Credit risk, on the other hand, arises as most corporate bonds are not secured with collateral, meaning that there is always a chance that the borrower defaults. To account for this type of risk, corporations are rated on a scale by credit agencies, with higher-rated bonds having lower interest rates and lower-rated bonds (“junk bonds”/”high-yield”) having higher interest rates in order to compensate for the additional risk. Well-known credit agencies include those such as Fitch’s, Moody’s, and S&P Global.

A credit spread/yield spread is the difference between the yield on a corporate bond and a government bond. Credit spreads can be used as a gauge for economic health – generally, a widening spread implies the economy isn’t doing very well and a tightening credit spread implies that economic conditions are improving.

The ICE BofA US Corporate Index Option-Adjusted Spread are the calculated spreads between an index of investment grade corporate bonds and a US Treasury curve. The spread was the widest in late March 2020 as a result of sudden economic shutdowns brought about by the pandemic but has been narrowing since then.

TECHNICAL ANALYSIS ON CHOICE OF ETF

The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD) is the largest corporate bond ETF in the world, and it would be remiss not to mention it. With about $52b AUM, an expense ratio of 0.15%, it is one of the most popular ETFs for new fixed income investors.

However, it doesn’t look like a good time to invest in the ETF now, for a couple of reasons – let’s start with the weightage of the fund. Almost 5% of LQD is weighted to oil and gas companies, 3.5% to retail business, and another 3.4% to pipelines. Not only are these the industries that are significantly affected by the pandemic, but oil and gas companies may take yet another hit with the arrival of the Biden administration. President Biden has already shown his commitment towards his climate change pledge within his first few days in the office by signing several executive orders, including one which pauses new oil and gas leases on federal land.

In addition, LQD may be slightly more susceptible to interest rate risk than most other bond ETFs. While LQD has a range of bonds across the maturity spectrum, the selection criteria mandates that all bonds have at least three years to maturity. With the weightage of the fund heavily skewed towards US companies (around 86%), this means that it may be at the mercy of rising US Treasury yields.

In general, it might not be the best time at the moment to invest in the corporate bond market. However, for investors who would like to dip their toes in right now, it may be worth to consider the Vanguard Short-Term Corporate Bond ETF (VCSH), which is a relatively stable ETF with modest returns. Although it does comprise of investment-grade bonds, the interest rate risk is much lower than LQD as the bond maturities are between 1 to 5 years. In addition, the expense ratio of 0.05% makes the ETF relatively cheap to hold.

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