Recently, the Bank of England announced a surprisingly aggressive set of measures. Included in the package was a £10 billion ($12.8 billion) investment-grade bond-buying program, which will purchase bonds from U.K. companies deemed to be making what the BoE calls a “material contribution” to the economy. This move, beyond being a potential catalyst for meaningful spread tightening, comes at an interesting time for investment-grade credit in general.
Given the sector’s strong returns so far this year, investors had understandably been asking whether the bid for high-quality yield can continue. The latest supportive expansion of the BoE’s toolkit into corporates, coupled with structurally powerful, long-term tailwinds already in place, suggests to us there is indeed more left in the tank in terms of investment-grade credit valuations.
As a potential indicator of where U.K. investment-grade credit may be headed, continental Europe may provide a clue. The European Central Bank’s staggeringly ambitious corporate bond–purchasing program has had a major influence. Since this latest wave of bond-buying was announced in March, spreads of eligible issuers have tightened by roughly 35 percent. If the ECB were to carry on at its current rate for the next three years, it would own as many corporate bonds as do all of the retail funds in Europe. This major incremental buying is a bullish signal underpinning corporate bond markets.
A number of other factors support the case for investment-grade credit.
If we look at the global impact of central banks on bonds across the spectrum, about one quarter of global bonds are trading on a negative yield. The sheer amount of negative-yielding government bonds is increasingly pushing investors into corporates as they seek positive returns. Relative to government bonds, investment-grade credit is throwing off a disproportionate level of income while still providing investors with a similar volatility profile.
It may sound counterintuitive at first blush, but a pickup in M&A activity is another likely positive for investment-grade credit. Historically, more M&A has meant widening spreads from increased issuance, but today, because of the huge demand, investors are now seeking liquid M&A-driven issuance. These bonds offer the market both a yield concession to existing securities from the company and liquidity, which has led to recent strong performance postissuance. We at J.P. Morgan Asset Management expect this trend to continue.
As important: Long-term trends for investment-grade corporates are also stabilizing. Debt growth is starting to stabilize relative to earnings (see chart), reducing overall leverage levels, which should help investor sentiment.
We continue to favor European investment-grade, not just because of supportive technical factors but also, given their conservative spending, because they tend to carry less leverage than their U.S. counterparts. Although spreads are already quite tight, we think there is even more tightening to come. In particular, we are constructive on long-duration investment-grade credit and bank issuers, which should continue to do well in a spread compression environment.
Much like economies, credit sectors move in cycles, making investment timing important. Having an early- to midcycle position today means finding companies that aren’t overly leveraged. That leads us to have high conviction in sectors such as utilities, banks, cars and building materials.
The combination of incredibly supportive central bank policy, strong structural tailwinds contributing to spread tightening and strong underlying fundamentals indicates to us that investment-grade credit’s strong returns have more room to run.
Andreas Michalitsianos is a portfolio manager with the European investment-grade corporate credit team at J.P. Morgan Asset Management in London.
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