Posted by lplresearch

Wednesday, March 02, 2022

Within the fixed income markets, the corporate credit markets can, at times, act like a canary in the economic coalmine. The return distribution for credit investors is asymmetrical, which means the potential for losses can be magnitudes larger than the potential for gains. So, credit markets tend to react quickly when economic conditions or corporate credit conditions start to deteriorate. And while fixed income markets broadly are down on the year, corporate credit markets (both investment grade and non-investment grade) are among the worst performing markets in the U.S. this year. Should investors take this as a sign that corporate credit markets are showing signs of stress? We don’t think so.

“U.S. corporate credit markets have underperformed this year but not because of increased credit risks, in our view,” noted LPL Financial Fixed Income Strategist Lawrence Gillum. “That we’re seeing broad based negative returns across most fixed income asset classes is largely due to higher Treasury yields and not deteriorating credit fundamentals.”

A Credit Default Swap Index (CDX) is a benchmark index that tracks a basket of U.S. corporate credit issuers and tends to act like an insurance policy in the case of an issuer’s default. In essence, credit default swaps strip out most of the interest rate risk of an issuer/security and measures just the credit risk. As seen in the LPL Chart of the Day, credit default swap indexes have increased this year but remain well within normal ranges.

As inflationary pressures have broadened this year, Treasury yields, across the curve, have increased due to expectations of Federal Reserve (Fed) interest rate hikes. That’s been the main driver of broad-based bond losses and we don’t think it should raise concerns about credit fundamentals. Moreover, we’re seeing the costs to insure the higher rated cohorts (the investment grade issuers) increase at a faster pace than the more default prone, non-investment grade cohort, confirming for us that the increase in cost is due to higher Treasury yields and not a deterioration in corporate credit conditions.

From a fundamental perspective, corporate balance sheets are still in good shape. Leverage ratios have increased recently, but net debt ratios (debt minus cash on the balance sheets) remain within historical norms. Also, due to the record amount of issuance over the last few years, companies were able to refinance debt at very low interest rates and push back when that debt was set to mature. As such, interest expenses have come down and now many corporations don’t need to access the capital markets anytime soon. We do continue to watch how these companies manage capital allocation decisions. Increases in M&A activity, share buybacks, and outsized dividends are all risks to bondholders and things that may lead to deteriorating credit fundamentals.

IMPORTANT DISCLOSURES

This material is for general information only and is not intended to provide specific advice or recommendations for any individual. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.

References to markets, asset classes, and sectors are generally regarding the corresponding market index. Indexes are unmanaged statistical composites and cannot be invested into directly. Index performance is not indicative of the performance of any investment and do not reflect fees, expenses, or sales charges. All performance referenced is historical and is no guarantee of future results.

Any company names noted herein are for educational purposes only and not an indication of trading intent or a solicitation of their products or services. LPL Financial doesn’t provide research on individual equities. All information is believed to be from reliable sources; however, LPL Financial makes no representation as to its completeness or accuracy.

All index and market data from FactSet and MarketWatch.

This Research material was prepared by LPL Financial, LLC.

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