- The fact that both equity and credit indices are rallying simultaneously may lead people to believe that the same things are good for equity and credit investors.
- Equity and credit investors have different motivations, but the Federal Reserve's market manipulations have made credit investors mimic equity investors in their risk taking.
- Yet, with credit spreads wide, we feel the signals given by the bond market have a greater value than those from the equity market
As the pandemic deepens, both equity indices and credit indices are rallying. It would be easy to conclude that what's good for stocks is also good for credit.
But it's not.
In fact, what's good for equity is often not good for credit. Typically, the things that move bonds are the opposite of what moves equities.
Equity and credit investors have different motivations. Credit investors want balance sheet strength. Equity investors focus on top-line revenue growth and swing for the fences in an attempt for tremendous upside.
In short, the Federal Reserve's maneuvers to stabilize both markets simultaneously are causing corporate credit investors to act like equity investors in their risk taking. For investors in credit risk it's 'game on.'
Total-return fixed-income investors have been driven to the market's higher yielding segments that have lower duration – Triple-B-rated bonds, speculative grade credit, leveraged loans, and some as- set-backed securities -- in order to reduce interest-rate risk. By moving away from high-quality corporate bonds into more volatile higher yielding areas they increase the risks that are more equity- like.
In an environment where both equities and fixed-income move in the same direction because of
cash infusions from the Federal Reserve, it's easy to lose sight of why it matters that what's good
for equities is not always good for credit. This perversion of the way markets should work means
credit investors need to remind themselves of how credit and equity investments differ.
Equities have unlimited upside, but no downside protection. In bankruptcy, equity investors can
lose everything. Credit, meanwhile, is a contractual agreement with limited upside. The chief benefit is the clear downside protection that places bondholders ahead of shareholders in bankruptcy. The best you can expect is to receive your coupon payments on time, principal back at maturity, and benefit from improvements in credit quality.
Equity investors love growth, even if it comes without profitability and balance sheet strength. Capital appreciation is the name of the game.
Credit investors love fiscal stability. The investment-grade bond universe typically has mature companies, which may have limited growth as their markets have been through years of healthy competition. To offset lower growth, the investment-grade companies have better balance sheets,
stronger cash flow, and fewer surprises.
Here is a list of things that are good for both equity and credit, and those that are not.
Good for Both:
• Corporate profitability and sustainable earnings growth
• Ease of access to capital and investor acceptance
• A stable, gradually expanding economy
• Supportive regulatory environment and legal framework
Good for Equities, Bad for Credit:
• Shareholder dividends
• Excessive share buybacks with debt
• Growth at any cost
• M&A at high multiples
• Increasing leverage
The Fed. However, there are many nuances here. In this pandemic environment, equity indices and credit indices have moved in the same direction, as company-specific factors, such as leverage and cash flow were dominated by market-wide dynamics, such as fear of COVID-19, the economic shut- down, an unprecedented spike in unemployment, and coordinated action by fiscal and monetary authorities worldwide.
Aware Asset Management believes the equity markets are discounting a high degree of optimism that assumes a rapid return to pre-pandemic levels of economic activity. That sentiment may prevail for some time, but it does not apply to credit markets.
The benchmark corporate bond index shows credit spreads are still more than 40% wider than pre-pandemic levels. This means credit investors are more critical of near-term recovery prospects, even as equity markets are near peak levels. The expected default rate is much higher than normal, around 14%. This should provide insight as to the difficulty facing credit markets right now. I question what about this environment makes investors willing to pay ‘top dollar’ for equities. In light of this, we feel the signals given by the bond market have a greater value than those from the equity market.
As credit investors we see a lot of downside risk now. Our expectation is that a full economic recovery will take years, and that credit spreads remain well wide of pre-pandemic levels. We think this reflects a more realistic view than the optimistic equity multiples. In addition, we think the credit markets have it right and that people need to be more cautious of interest-rate risk.
We favor companies who have articulated and demonstrated their commitment to a strong balance sheet and responsible management. This gives us confidence in their ability to navigate the damage from the pandemic, however long that takes.
As we have said previously, we believe ‘BBB-rated bonds’ offer the best balance between higher yields, and therefore lower duration, lower interest-rate risk, and better credit protections.
Ian C. Carroll, CFA, CIPM
Head of Corporate Credit Research
Aware Asset Management
Investing involves risk, including the loss of principal.