December 15, 2016
The key themes that drove returns in the second quarter continued through the third quarter. Robust issuance, totaling $323 billion in the third quarter, was absorbed by domestic and foreign investors hungry for yield. This technical backdrop has driven yields to unattractive levels. Fixed-rate primary market bonds priced at average yields of only 2.9 percent in the third quarter, despite maturities averaging more than 12 years, making it difficult to find compelling value. There is little indication that demand will ease in the near term as global yields anchor those in the U.S.: euro-denominated investment-grade corporate bond yields are a full 220 basis points lower than U.S. investment-grade corporates. We are watching hedging costs closely as we assess the potential for foreign demand to wane. For European and Japanese investors, hedging the U.S. dollar would eliminate over half of the excess yield over their respective local bonds, but this cost has not deterred demand for now. The ratio between foreign purchases and new issuance volume through July 2016 is at post-crisis highs.
Foreign capital is fleeing to the U.S. as foreign corporate yields circle zero. Both the level of foreign purchases and measured as a ratio of new U.S. corporate bond issuance is at post-crisis peaks in 2016. Foreign investors are likely to represent a large share of overall demand over the next few years as foreign central banks maintain accommodative monetary policies.
Source: Bloomberg, U.S. Treasury Department, SIFMA, Guggenheim Investments. Data as of 7.30.2016.
The Barclays Investment-Grade Corporate Bond index delivered a 1.4 percent total return during the third quarter, its third consecutive quarter of positive returns. Spreads tightened by 18 basis points quarter over quarter to 138 basis points, with the biggest moves once again stemming from spreads tightening in energy and basic materials. Higher commodity prices have attracted buyers in both sectors, but the opportunity in commodity credit is almost over. Spreads in energy and materials are at their tightest in over a year.
With our Macroeconomic Research team estimating that the next recession remains two to three years away, we believe the rally in the investment-grade market is not over, and we expect to see more spread compression. In the near term, we will be looking to sell into strength and buy on weakness. Episodes of high volatility may yield opportunities that do not exist in a market that is seeing bonds priced inside of 3 percent yields and secondary bonds trading at significant premiums to par. We will focus in the coming months on higher quality and timely relative-value opportunities.
Recovering oil and metals prices have attracted investors to commodity-related credits, absorbing much of the value that we saw in the space at the beginning of the summer. Corporate bond spreads in the energy and metals sectors have tightened to levels observed before the nine-month selloff that peaked in February, but they continue to offer better value than other sectors.
Source: Barclays, Guggenheim Investments. Data as of 10.17.2016.
—Jeffrey Carefoot, CFA, Senior Managing Director; Justin Takata, Director
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