The bubble in artificial intelligence stocks is not the only worrying sign of exuberance in financial markets today.
Narrowing corporate bond spreads have been another factor that appears to suggest overconfidence among investors.
However, fixed income managers argue that corporate bonds in aggregate are much less risky than they used to be, and may be less risky than the sovereign bonds of highly indebted nations. Spreads are merely reflecting reality. Is this wishful thinking?
Corporate bond spreads have ticked higher since the start of October, but remain near decade lows.
The relative yields of government and corporate bonds appear unusual, but these are unusual times
They have been supported by positive economic growth, manageable supply, central bank interest rate cuts and ongoing high demand.
Default rates are low, and with a diminishing prospect of recession in the US, are expected to remain so.
Nevertheless, it has left corporate bonds vulnerable.
As Colin Finlayson, manager of the Aegon Strategic Bond fund, says: “As spreads get tighter, the size of the speed bump needed to derail the market gets smaller. We’ve seen little flashes of that recently with some nervousness around developments within the private credit market.
“At the same time, the supply of bonds into the corporate bond market seems to get ever higher, and this will test the underlying demand and appetite from investors in the period ahead.”
But there is an alternative argument gathering pace: many corporate bond managers say the relative merits of government and sovereign bonds have shifted.
Investors are still well compensated for the risks they are taking on a corporate bond, and therefore spreads could still go lower, or even turn negative.
There are already isolated examples of corporate bonds trading at lower yields than the equivalent sovereign bond, including Microsoft and Johnson & Johnson.
Stephen Snowden, manager of the Artemis Corporate Bond fund, says: “Credit spreads may appear tight, but the optics are misleading. We think they have plenty of room to tighten further. Our rationale is this: corporate bonds are a lot less risky than they used to be. Companies have been cleaning up their balance sheets and are much less indebted than they were a decade ago.”
In the meantime, he says, government balance sheets have gone in the opposite direction. “After borrowing heavily to support their economies through the global financial crisis, governments have recently been ramping up their spending on defence and infrastructure.”
US debt is now $38tn (£28.7tn). Attempts to curb the debt have been largely unsuccessful, with the Doge experiment failing to secure any major cuts in government spending.
Snowden points out that the corporate bond market’s duration has come down, so investors are taking on less risk by lending to companies over shorter time periods.
Companies now tend to issue five or 10-year bonds, whereas a couple of decades ago, 20 to 30-year bonds were commonplace.
“Ipso facto, investors and asset allocators concerned about tight spreads are fixating on the wrong thing, in our view.
“Given how much credit risk has come down in recent years and how high starting yields are presently, it would be a shame if the optical illusion of tight spreads hid from view the attractive risk-adjusted returns on offer.”
Daniel Morgan, an analyst on the Ninety One multi-asset team, which manages the group’s Diversified Income fund, agrees, saying that although debt sustainability trends appear negative for developed market sovereigns, the corporate bond market has decreased leverage since the Covid-19 crisis, with aggregate leverage now at its lowest level in a decade. This makes comparisons between the two areas more complicated.
It is also worth noting that while it may be unusual for corporate bonds to trade at a lower yield than government bonds in developed markets, this has been a feature in emerging markets where a well-run company may be considered a better option than a badly run government.
As populist governments threaten established institutions in developed markets, a similar phenomenon may be evident.
Morgan says Ninety One does not differentiate between sovereign and corporate borrowers in its credit loss forecasts, and sees evidence that other bond investors are doing the same.
“We see evidence of an absolute perspective emerging in credit markets, as the sovereign ceiling for corporates no longer holds in all cases. Across both emerging markets and the Eurozone, there are corporate issuers trading inside their sovereign yield curves.”
He says this can continue: “Over time, we may see more corporate issuers with higher ratings and lower yields than their sovereigns, as the fortunes of high-quality global businesses can at times diverge dramatically from the domestic fundamentals of their home country.”
There are caveats to this. Highly indebted governments can create risks in the private sector. They can raise taxes, for example, which could affect the creditworthiness of companies.
High government borrowing can also crowd out other areas. There is a limited pool of bond buyers, and if they can get high yields on government debt they may choose not to invest in corporate bonds.
Equally, it does not remove the need to be highly selective in corporate bonds.
Finlayson at Aegon says: “What we don’t want is exposure to generic credit risk, as this is the part that we think is expensive. So we’re able to hedge out a lot of that risk using [credit default swap] indices and to focus on those attractive opportunities within individual sectors and securities.”
The relative yields of government and corporate bonds appear unusual, but these are unusual times.
The relative creditworthiness of each type has changed as government debt has risen and corporate debt has fallen.
Tight spreads may not be the source of vulnerability they initially appear.
Darius McDermott is managing director of Chelsea Financial Services