On the road again: a bond investor’s travel guide
US corporates are in the recovery stage of the credit cycle thanks to their focus on bondholder management, and ongoing support from central banks with low rates creating benign financial conditions. The main task for corporates is to work on repairing balance sheets and credit metrics, such as leverage, cash flow and margins. New virus mutations, sudden inflation flare-ups or changes in central bank policy could disrupt this process, which is however unlikely.
The other side of the coin of the US recovery are rising US yields in Q1 2021 as inflation expectations have been increasing. However, inflation expectations have run a bit too far since actual inflation numbers are likely to be lower than what the market is pricing in at the moment.
The recent Fed meeting has provided comfort as Chair Powell insisted that he would focus on realized progress not just forecast progress, both on employment and inflation: inflation must be judged sustainable whilst labor market progress must be broad and inclusive before any Fed action can be expected. In addition, the Fed minutes showed that the committee members remain cautious with regards to the economic recovery and do not feel any urgency to remove accommodation.
For US corporate bonds, higher yields have so far not become a concern for credit fundamentals as borrowing costs are still well below existing coupons, Fed policies remain highly accommodative and economic momentum is positive. In addition, companies have been very active with bond tenders: buying back old bonds with relatively high coupons and replacing them with newly issued bonds with lower coupons. This will positively contribute to company earnings as interest expenses have been lowered. Higher yields and therefore higher re-financing costs will not weigh much on profitability. Currently, cyclical sectors benefiting most from the recovery look particularly attractive: Automotive, Basic Industries, Energy and Banking. Travel or transportation should be treated with caution.
The solid investor demand for newly issued bonds is probably also a result of default rates drifting lower. Default expectations are painting an improving picture with a baseline forecast by Moody`s for the next 12 months of below 4% which is below the historic average.1 Major contributors to defaults remain the Oil & Gas and Retail companies. For Investment Grade rated companies, defaults and bankruptcies typically play a minor role.
Before 2017, the US had one of the highest corporate income tax rates among the OECD countries. In 2017, the corporate income tax rate was reduced from 35% to 21%. Now, we can expect some of this to be reversed, as President Biden has proposed several changes to corporate taxes to raise revenues for his infrastructure plan. At the beginning of April, the roadmap to pay for the American Jobs Plan was released, called “The Made in America Tax Plan”. The biggest change from a revenue standpoint would be to raise the corporate income tax rate to 28% from 21%. A general rule of thumb is that a one percentage point increase in the corporate income tax equates to approximately $100 billion of new revenues per year. However, an increase in the corporate income tax rate needs the support in either the Senate or the House. As a result, a compromise is quite likely, with the corporate tax rate finally landing around 25%. Such a moderate increase in corporate income tax rate is manageable for US corporates. More generally, a compromise settling on a lower tax rate than initially thought could ultimately be positive for risk assets, including corporate bonds.
1. March 2021 Default Report, Moodys Investor Service.