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As the market recovery loses momentum, have corporate bonds reached a turning point?

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The views expressed in these posts are those of the authors and are current only through the date stated. These views are subject to change at any time based upon market or other conditions, and Eaton Vance disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for Eaton Vance are based on many factors, may not be relied upon as an indication of trading intent on behalf of any Eaton Vance fund. The discussion herein is general in nature and is provided for informational purposes only. There is no guarantee as to its accuracy or completeness. Past performance is no guarantee of future results.

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      By Bernard Scozzafava, CFADirector, Taxable SMA Strategies, Parametric and Thomas H. Luster, CFAManaging Director, Taxable SMA Strategies, Parametric

      Boston - Both credit spreads and Treasury rates have stabilized since mid-April, causing corporate bond returns to flatten after an exceptional rally. With the economy edging back toward reopening and the Federal Reserve's quantitative easing program entering its next phase, we aren't concerned by this lack of market momentum. While the balance between supply and demand has turned less favorable recently, we continue to view intermediate investment-grade (IG) corporate bonds in a positive light.

      Putting aside the recent lack of progress, the recovery in corporate bonds has been remarkable. By the third week of March, the year-to-date (YTD) return of the ICE BofA/Merrill Lynch 1-10 Year US Corporate Index was ‑7.75%. The loss was driven entirely by wider credit spreads, which were partially offset by lower Treasury yields. The market essentially stopped functioning in mid-March, which prompted the Fed to announce a stunning array of programs designed to improve liquidity. The decisive intervention unsurprisingly flipped the market's risk profile, encouraging buying rather than selling, and credit spreads narrowed sharply. By the end of April, the ICE BofAML index's YTD total return was positive at 0.55%, and its yield to maturity of 2.54% was nearly identical to that at the beginning of the year.

      New issuance accelerating

      Corporate bond demand returned but couldn't keep pace with accelerating new issuance, putting the rally on pause. New issuance has been so strong that YTD net supply is on pace to set a record for full-year net issuance totals. This has pushed spreads modestly wider, raising concerns of supply fatigue. However, we view the issuance as a positive. Companies are using sale proceeds primarily to add a liquidity buffer to balance sheets, not for dividends, buybacks, or capital expenditures. The new supply has consequently lifted net leverage ratios only modestly.

      Increases in new issuance historically haven't put material pressure on secondary corporate bond prices. This is because extra supply tends to come in response to strong demand, enabling companies to finance at attractive rates. Companies today are less sensitive to rates and more concerned about their cash balances. The increased supply has nevertheless received solid demand, with newly issued bonds generally trading well in the secondary market.

      Fed offering support

      The Fed's liquidity support announcement marked the turning point for IG and other credit assets. May 12 saw the initial investment into credit ETFs, and the purchase of individual IG corporate bonds will begin as soon as the logistics of the Fed programs are finalized. While these purchases may not actively drive spreads tighter, we believe they represent a significant and price-agnostic bid beneath the asset class, which should help provide liquidity if the market begins to trade lower again. The Fed has left little doubt in the meantime that it's the buyer of last resort, standing ready to intervene in the market to the degree necessary to support these assets.

      Credit spreads reflecting uncertainty

      IG credit spreads remain wide by historical standards despite the rally from their recent highs. Current spreads of roughly 2% over Treasurys are consistent with what the market has viewed as fair compensation in prior periods of severe stress or recession. Should credit downgrades increase or rates begin to rise, we think this 2% offers a significant performance cushion.

      Despite these positives, uncertainty around the future path of the economy remains high. A lack of clarity regarding the pace and extent of economic reopening has caused numerous management teams to stop offering forward earnings guidance. Restoring consumer and business confidence against a backdrop of an unemployment surge and a GDP contraction of up to 30% will prove difficult. We agree with Fed chairman Jerome Powell's April 29 characterization of the prospects for the US economy as being "so uncertain as to be unknowable."

      Bottom line: It's been our experience that market trends never occur in a straight line, so the pause in this rally isn't surprising. Yet spread levels are attractive, the Fed is willing to offer nearly unlimited support to the markets, and corporate liquidity positions have improved. While we can't be sure what a future driven by COVID-19 will look like, we continue to view IG bonds favorably.