Risk vs. reward: comments on corporate bonds

Brandon Snow's picture

I wanted to share a few charts that have me thinking more about the risk in corporate bonds. We have spoken about the lack of return potential, relative to risk, within high-yield bonds for a number of years. But a few charts shared by our team recently show these concerns extending into investment grade (IG).

 

  1. IG leverage at record levels even though we are not in a recession: 
  • Today, we are seeing leverage peak while the economic environment is benign. Historically, leverage peaks during recession (debt stays flat, earnings decline). Low yields have allowed this to occur as interest coverage has been robust, but we don’t usually stay at these levels forever.
  1. Balance sheets are expanding, not supported by underlying growth:
  • Little topline growth has driven companies as a whole to increase leverage, cut costs and buy back stock. This is unsustainable in the long run and why we think it’s so important to dig into a company’s fundamentals and understand the source of its growth and sustainability.

  1. Firm level valuations are high (i.e. stocks fairly valued and bonds expensive):

    Source: Bloomberg

The corporate debt situation is uncomfortable across the market, with little buffer for an economic shock. If government rates have bottomed and cost inflation is picking up as indicators suggest, we could see corporate profitability squeezed, spreads beginning to widen again and companies unprepared for it getting hurt. This is why we have been focusing on quality in our funds: pricing power and strong balance sheets are undervalued in the market and we will continue to focus on companies with these attributes.

We are often asked why our cash levels are so high and the answer is simple – the market isn’t giving us appropriate risk-adjusted returns to be fully invested. We have a long (and growing) list of companies we are ready to invest in. We will continue to be patient with the price that we are willing to pay for these companies.

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