The case for lower rated corporate bonds

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1 The case for lower rated corporate bonds Marcus Pakenham Fixed income product specialist December 3 Introduction Where should fixed income investors be positioned over the medium term? We expect that government bond yields will trend higher as global economic growth improves and some quantitative easing (QE) programmes cease expansion. In this environment, government bonds and high grade corporate bonds may struggle to achieve positive returns with low starting yields and the headwind of rising yields. By contrast, we believe that lower rated corporate bonds such as BBB rated and high yield BB and B rated areas can provide attractive returns for investors in this scenario. These areas have higher starting yields and the duration, or sensitivity to movements in government bond yields, is generally lower than for higher rated corporate bonds. In this paper we look at the economic environment and its likely positive impact on bond markets, the interplay of bond prices during periods of rising government yields and why we believe the environment is positive for some parts of the lower rated global corporate sector. 3 - Global economic growth is improving Below we show forecasts for global growth from Consensus Economics. The following graph shows moderate, but below trend, 3 growth in most developed economies. We believe that economic performance has been reasonable given the impact of government austerity campaigns. The IMF has estimated that the impact of this fiscal drag in 3 has been -.% in the US, -.3% in the UK and -.9% in the Euro area. One reason why we expect economic growth to improve in is that these fiscal drags should ease in these areas. Forecasts for 3 & GDP growth. 3 Real GDP % growth Real GDP % growth World US Eurozone UK Asia Pacific Latam Source: Consensus Economics, data as at November, 3. PMI Surveys 3 US: ISM Manufacturing PMI SA EU: EC Manufacturing PMI Overall Index UK: UK Manufacturing PMI Overall Index Japan: Nomura/JMMA Japan Seasonal PMI 3 Jan 7 Jan Jan 9 Jan Jan Jan Jan 3 Source: Bloomberg, data to November 3 3. This economic growth outlook should be positive for corporate bonds. The quality of balance sheets is affected by economic conditions with rising sales and healthy liquidity conditions generally good for company fundamentals. In particular, defaults in high yield are usually linked with broad financial distress and difficult economic conditions, which we do not expect. It is interesting to note that Moody s utilise the unemployment rate as a key component in default forecasts. If we look at the manufacturing PMI surveys in the next graph, the data is well above in the US, Japan and the UK and just above in the Euro zone. Numbers above indicate expansion and manufacturing tends to lead other parts of the economy such as services.

2 9 7 3 Inflation has been one of the biggest threats over the long term for bond market returns. The forecasts in the graph below show that inflation is expected to remain moderate in, despite the expected improvements in economic activity. Forecasts for 3 and inflation 3 Consumer Prices % increase Consumer Prices % increase US core tier capital ratio (%) European core tier capital ratio (%) US loan loss provisions/gross loans (bps) (RHS) European loan loss provisions/gross loans (bps) (RHS) 7 9 3e. 7.3 World US Eurozone UK Asia Pacific Latam Source: Consensus Economics, as at November 3. Global monetary conditions are also improving An important component of any economy is monetary conditions. Broad money is largely created and held within the private banking system. In the US and Europe since the economic crisis in, banks have generally struggled with weak balance sheets leading to difficult monetary conditions for corporates and individuals. Indeed, various Central Bank measures, including QE, were enacted partly to help money flow through the system. Banks have recently made great strides with loan losses and raising capital ratios and are in a better condition to support economic growth without additional Central Bank support. The graph below shows how banks have boosted capital ratios since the crisis through retained earnings, raising fresh equity finance and reducing balance sheet liabilities. These ratios are now well above the pre-crisis levels. The lines show the loan loss provisions with the real estate problems in the US very clear from the higher level of provisions. Bank capital ratios and loan loss provisions 3 Below we also show how broad money aggregates have recovered since the crisis. The levels of growth are close to rises in nominal GDP growth. Recent data in the Euro zone has weakened. There is also a particularly encouraging improvement in Japan as the central bank seeks to boost economic activity. Broad money aggregates, YoY changes - Jan-7 Jan- Jan-9 Jan- Jan- Jan- Jan US Divisia M UK M exc OFCs ECB M3 Japan M & CD Source: US M Centre For Financial stability, UK M from Bank of England, other data from Bloomberg, data as at 3 November 3. UK M data quarterly until July, monthly thereafter. The graph below captures lending conditions in the US and Europe. Banks are regularly asked if their customer lending conditions are being tightened or loosened. A rising line shows an improving situation. The significant banking problems after the Lehman collapse can be seen in late with a rapid improvement in 9. The dip in reflected lower confidence while the Euro area grappled with sovereign debt issues in Italy and Spain. US banks are still loosening banking standards, but by less than in September. Lending conditions US Net % of Domestic Respondents Tightening Standards - C&I Loans for Large/Medium Companies, (LHS) ECB Survey Change Lending to Business Last 3mth net percentage Bank's (change in bank's credit standards) (LHS) Jan Jan 7 Jan 9 Jan Jan 3 Source: Bloomberg, as at November 3, 3. We expect lending conditions to improve further in the US and Europe. Source: Autonomous Research, as at 9 August 3, European data average of 9 banks, US average of Bank of America, Citigroup and JP Morgan.

3 The Great Normalisation of government bond yields and Central Bank policy rates Under this improving economic scenario, we expect government bond yields to slowly rise and move to more normal levels. There are various ways to consider how government yields might move over a medium term period. One of these is in relation to the level of nominal GDP. In the past, long term government bond yields have been close to rates of nominal GDP growth. Nominal is broadly defined as real growth plus inflation. Looking forward, in the US this nominal growth might be between.% and.%, while in Europe it might be in a slightly lower range of 3.% and 3.%. At the current time long term government bond yields are well below these levels (using German yields as a proxy for the Euro area). We would therefore expect year US government bond yields to move closer to this % over the next to 3 years. Shorter government yields, such as for year bonds will be held down by very low policy rates in the meantime. Recent periods of rising US government yields and policy rates In the US these policy rates are unlikely to move higher until late or early. As a result, short term bond yields are likely to remain low for some time. We would expect Euro government yields to follow similar broad trends but with a lag, reflecting the different timing and extent of economic improvement in the US and the Euro area. The graph below illustrates the previous cycles of rising government yields and policy rates from 99. year yields tend to move well ahead of the policy rate increases while the year yields rise more closely with the timing of the policy rate increases. The graph also shows how and year government bond yields and policy rates have been at the same level at the end of the tightening cycles. - US Fed funds rate, % year US treasury yield, % year US treasury yield, % US GDP Nominal Dollars YoY % SA Source: Bloomberg and HSBC Global Asset Management, as at November 3 3. Corporate bond yield spreads have often fallen while government bond yields rise Corporate bonds have often provided positive returns despite rising government yields as the yield spread between the two security types has fallen. Rising government bond yields usually reflect stronger economic conditions. This is generally positive for the corporate sector as the stronger economic conditions are positive for company fundamentals and the risk premium for owning corporate bonds can fall. This is captured through lower yield spreads between government and corporate bonds. Recent periods of rising US government yields and movements in credit spreads As we can see in the graph below, when US year government yields have been rising, high yield spreads have usually fallen and investment grade spreads have been broadly unchanged. These periods have been highlighted by the grey areas. 7 3 year US treasury yield, % US IG Spread, bps (RHS) US HY Spread, bps (RHS) Source: Bloomberg and HSBC Global Asset Management, as at November 3 3.

4 Corporate bonds have usually produced positive returns while policy rates have increased In the table below we highlight the three periods when policy rates have risen over the last years. We show Federal Funds as the US policy rate, the broad Barclays US Treasuries index as representative of the US government bond market and three corporate indices: investment grade, high yield and short duration high yield. For each period we show where the yields started and the amount of yield increase over the period. The periodic return shows the total return over the same period. Bond returns during periods of rising policy rates Most bond sectors have made positive returns during these periods of rising policy rates. In the June 999 to June period, the high yield index had a negative return because of the considerable defaults during that period. These problems arose from the confluence of the Asian crisis, the Russian sovereign default and the bursting of the technology bubble. As we discuss below, we expect corporate fundamentals to remain positive. December 993 to February 99 ( months) Surprise rise in policy rates June 999 to June ( months) Recovery from short crisis March to June (7 months) normalisation of policy rates 3 November 3 % Dec 93 change to Feb 9 Periodic return Jun 99 change to Jun Periodic return Mar change to June Periodic return 3 Nov 3 Federal Funds Target Rate US Barclays US Treasuries Barclays US Corp (IG) Barclays US HY Bof A ML -3 Year US HY NA Source: Bloomberg and Barclays Live, periods from end of month to end of month. The full name of the ML -3 US HY index is The BofA Merrill Lynch -3 Year Cash Pay High Index. The corporate sector is healthy Unlike governments, the corporate sector, ex-financials, was in pretty good shape going into the economic crisis in /9 with reasonable balance sheets, good margins and healthy cash flow. The severe problems in the banking system were very problematic for day-to-day liquidity management. Central Bank operations were initiated to help banks continue support for the wider corporate sector. The situation in late and early 9 was very difficult and most Boards told management to reduce costs and conserve cash. This broadly conservative management has placed the corporate sector in a strong position to ride out the subsequent economic landscape with growing cash flows in most sectors in the US and Europe. Banks have also made great strides in increasing capital and liquidity ratios. As US economic growth picks up momentum and Europe emerges from recession, we are seeing moderate growth of leverage in some areas, but cash flows remain robust and ratios that measure the ability to service debt are well within acceptable ranges. The graph below shows the trends in cash flow for non-investment grade companies. We have used EBITDA which is earnings before interest payments, tax, depreciation and amortization. Global high yield EBITDA growth 3 HY EBITDAs, YOY Pct Change The graph below shows this EBITDA in relation to the interest expense on debt. This shows that this ratio has risen strongly since the economic recession in 9 and is close to the highest levels since 99. Global high yield fixed charge coverage ratio: EBITDA/interest expense (rolling months) HY Coverage Ratio. 99 Source: Bank of America Merrill Lynch, as at June 3 3. As discussed earlier, corporate defaults usually occur during periods of financial distress so this healthy fixed charge coverage ratio is an important signal that defaults should remain at a low level Source: Bank of America Merrill Lynch, as at June 3 3, Earnings before interest, taxes, depreciation and amortization.

5 Rating migrations and default rates are low We can also monitor the health of corporates through rating migrations and defaults. When a company credit rating changes it is deemed to have migrated and so monitoring migrations can show how the perceived quality of credit quality is changing. The graph below shows investment grade migrations for US and EM corporates. After a balance of negative migrations in 9 and some volatility in EM ratings in, investment grade migrations are low with little change over the last months. Investment grade migration rates for US, EU and EM (% of issuers) Upgrade Trailing 3mo Rating Migration Rate - US IG EU IG EM IG Downgrade - 99 Corporate sector valuations are reasonable Corporate bonds have a higher yield than government bonds. The spread between a corporate and its government bond is a measure of valuation for the corporate bond. This spread can reflect the risk of not being repaid in full versus a riskfree government bond. This can be reflected in a rating downgrade for investment grade, or a rating downgrade or a possible default for a high yield company. In addition, spreads can reflect taxes, liquidity, economic uncertainty and supply and demand factors. Below we consider various measures to assess the valuation of corporate debt, especially the lower rated credit such as BBB, BB and B rated bonds. One broad measure of valuation is comparing the yields of various quality of bonds with historic loss rates. Here, loss rates reflect % defaults less the recovery that is made for investors as bond holders often receive some level of repayment after a company defaults. The graph below shows this relationship and highlights the gap between the current level of yields and the historic loss rates for BBB, BB and B rated bonds. Global fixed income corporate yields and loss rates (%) Source: Bank of America Merril Lynch, as at September 3 3. For high yield, the negative migrations were greater in 9. The graph below shows migration rates for high yield companies in the US, Euro area and EM. Migration rates have eased, but are still slightly negative in Euro and EM areas. The US is broadly stable. High yield migration rates for US, EU and EM (% of issuers) Upgrade to Worst Average cumulative year credit loss rates, Global Corporates, 9- AAA AA A BBB BB B CCC-C Trailing 3mo Rating Migration Rate - US HY EU HY Trailing 3mo Rating Migration Rate - EM IG US HY EU HY EM HY Downgrade Source: Bank of America Merrill Lynch, as at September 3 3. Current default rates are at a low level and well below historic averages. Global high yield default rates (% of issuers) Source: data source - Bloomberg/ML Global Broad Market Corporate and Global High corporate indices, November 3 3. Credit loss data source - Moody s Annual Default Study Corporate Default and Recovery Rates, 9-, dated February 3. Credit spreads have moved within very large ranges since the crisis but the amplitude of swings has reduced. As investors increasingly look at corporate credit from a fundamental stand point, we expect yield spreads to be much less volatile and indeed should be able to fall over time. Option adjusted spreads (%) US Baa Corporate US High Ba EM USD Aggregate Index Euro Corporate Baa (USD) Euro High BB (USD) Jan Jan 7 Jan Jan 9 Jan Jan Jan Jan 3 Source: Barclays index data, Barclays Live as at November 3 3. Source: Bank of America Merril Lynch, as at September 3 3.

6 As discussed, there has been a close correlation between lending conditions and the valuation of high yield bonds. In the graph below we show the US lending conditions from the earlier graph and add the US BB and B rated high yield spreads. This shows how spreads can fall as the balance of lending conditions improve. US lending conditions and US$ BB-B spreads - - US Net % of Domestic Respondents Tightening Standards - C&I Loans for Large/Medium Companies, (LHS) BofA ML US High, BB-B Rated, Constrained Index spreads (RHS, basis points) Conclusion We have seen how the economic conditions are improving globally. We expect government bond yields to trend higher over the medium term as QE programmes ease and economic momentum builds. In this environment we believe that lower rated corporate credit, such as BBB, BB and B rated bonds can provide attractive returns: the corporate sector is fundamentally strong with good cash flows providing comfortable cover for current debt levels; further we believe that the valuation of corporate bonds is reasonable. Jan- Jan-7 Jan-9 Jan- Jan-3 Source: Bloomberg, as at November 3 3. We also see in the graph below how the differentials between the BBB and high yield ratings have moved over the last years. The lines show the differentials between US BBs and BBBs, US Bs and BBs and US CCCs and Bs. We can see the much higher volatility in CCC spreads, especially during times of corporate stress. This is understandable as CCC rated securities carry most default risk. We have chosen to exclude CCC rated securities from our strategy benchmarks as these bonds tend to add considerable volatility through a cycle, without adding significant extra return. By contrast, the differentials between BBs and BBBs, and Bs and BBs, have been much less volatile and have eased back to the levels in mid. Spread differentials between ratings (basis points),, US BBs vs BBBs US Bs vs BBs US CCCs vs Bs,, Source: Bank of America Merrill Lynch, as at November 3. When we consider these various measures of valuation we conclude that lower rated corporate spreads are reasonable for the economic and fundamental environment.

7 This document is intended for Professional Clients only and should not be distributed to or relied upon by Retail Clients. The contents of this document are confidential and may not be reproduced or further distributed to any person or entity, whether in whole or in part, for any purpose. The material contained herein is for information only and does not constitute investment advice or a recommendation to any reader of this material to buy or sell investments. This document is not intended for distribution to or use by any person or entity in any jurisdiction or country where such distribution or use would be contrary to law or regulation. This document is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe to any investment. HSBC Global Asset Management (UK) Limited has based this document on information obtained from sources it believes to be reliable but which it has not independently verified. HSBC Global Asset Management (UK) Limited and HSBC Group accept no responsibility as to its accuracy or completeness. The views expressed above were held at the time of preparation and are subject to change without notice. Any forecast, projection or target where provided is indicative only and is not guaranteed in any way. HSBC Global Asset Management (UK) Limited accepts no liability for any failure to meet such forecast, projection or target. The value of any investments and any income from them can go down as well as up and your client may not get back the amount originally invested. Where overseas investments are held the arte of currency exchange may also cause the value of such investments to fluctuate. Investments in emerging markets are by their nature higher risk and potentially more volatile than those inherent in some established markets. The value of the underlying assets is strongly affected by interest rate fluctuations and by changes in the credit ratings of the underlying issuer of the assets. HSBC Global Asset Management (UK) Limited provides information to Institutions, Professional Advisors and their clients on the investment products and services of the HSBC Group. This document is approved for issue in the UK by HSBC Global Asset Management (UK) Limited who are authorised and regulated by the Financial Conduct Authority. Copyright HSBC Global Asset Management (UK) Limited 3. All rights reserved. Approved for use with Professional Clients only. 9 / FP3-99 / //. 7

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