The exuberance in U.S. corporate bonds follows that in stocks but is likely to end soon, according to Gluskin Sheff chief economist and strategist David Rosenberg.
Investing in the asset class isn’t being driven by economic growth but by the ongoing drive for yield.
The “dividend aristocrat” theme of investing in companies that have been raising their dividends for the last 25 years is alive and well. Investors are starved for higher yields in a still ultra-low interest rate environment, and U.S. corporate bonds are benefiting.
“You have a very expensive stock market so it stands to reason that you have a very expensive corporate bond market. The two are basically correlated assets,” Rosenberg said in a phone interview.
“I’m worried about the valuations of both asset classes, frankly speaking,” Rosenberg added.
In baseball parlance, Rosenberg said the U.S. economic cycle is somewhere in between the seventh-inning stretch and the top of the ninth. Now is the time to focus on high-quality companies with good liquidity in non-cyclical industries.
Early signs show investors are starting to take a more defensive posture. Money is moving out of high-yield bonds, while investment-grade bonds are attracting inflows. On the stock market side, it’s the large cap stocks outperforming the small caps, while utilities, telecom, and consumer staples have their day in the sun.
But there is still plenty of exuberance to be seen. In late July, AT&T issued $22.5 billion of debt drawing almost three times as many orders as there were bonds for sale.
Rosenberg called Iraq’s oversubscribed first unguaranteed sovereign bond in a decade—a $1 billion 6-year bond yielding 6.75 percent—the “most egregious development over the past month.”
“It’s not supposed to be this easy and something tells me that because it is so easy to float all this debt, that it is the investor and not the issuer that’s going to end up bearing the burden,” Rosenberg said.
End to Good Times
The major central banks’ purchases of bonds was a boon for stocks and corporate bonds, but with the impending start of the U.S. Federal Reserve reducing its $4.5 trillion balance sheet, a less friendly central bank environment looms.
“It stands to reason that risk assets will underperform. Period,” Rosenberg said. As investors sought higher yields and bore the accompanying risk while the Fed increased its balance sheet, the reverse action from the Fed should lead to higher long-term interest rates and investors dialling back their risk appetites.
Globally, it’s been a very good run for bonds along with stocks since the U.S. election.
Investment-grade debt is on pace for a record year with $1 trillion issued year to date. High-yield issuance of almost $250 billion is elevated though not as high as it was in 2013 and 2014.
“Right now, we’re priced for too-low volatility across the board and too much risk-taking,” said Peter Tchir, head of macro strategy at Brean Capital, in a Bloomberg interview.
Though the market still feels healthy to him given its selectivity on which deals perform well and which don’t, he said there’s been too much issuance.
“It just feels that this issuance has to be digested.”
High-quality corporate bonds are less sensitive than stocks to the current slate of risk factors like the U.S. debt ceiling and geopolitics, according to Tchir.
Investment-grade debt has a natural set of buyers, but investors aren’t legally compelled to own high-yield, which has seen some weakness.
Investment-grade bonds yield about 1 percent more than U.S. government bonds and high-yield bonds about 4 percent more. Both spreads are near their recent tightest levels from 2014.
High-yield defaults have declined to 3.65 percent from a peak of 5.8 percent, according to the rating agency Moody’s.
Some of the issuance from the United States is trickling into Canada. It’s the busiest year since 2007 for foreign issuers in the Canadian market with roughly C$9 billion raised, according to Thomson Reuters. Apple’s C$1.5 billion deal on Aug. 15 was the biggest single-bond deal by a foreign issuer.
Rosenberg doesn’t think U.S. equity and corporate-bond valuations are sustainable at the current levels. He advises investors to “play the middle 50 percent.” It’s difficult to get rich by consistently buying at the lows and selling at the peak.
“We’re late in the cycle and it means a more defensive posture … if you’re an investor.”
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