Our Answers to Three Key Questions about Short-Term Corporate Credit

Lord Abbett experts offer their perspective on the asset class in the context of current economic and market conditions.

In Brief

• Among the topics addressed in a recent Lord Abbett webinar on short-term fixed income was the state of the investment-grade corporate bond market.
• Our experts discussed the potential impact on the asset class of recent actions by legislators and central bank officials, including the U.S. Federal Reserve’s extension of its lending program.
• Also covered was the historical default rate of investment-grade short corporates in the past few decades, and the investor experience during periods of market stress.
• Finally, a Lord Abbett portfolio manager spoke about areas where he sees potential opportunity in short corporates, including the health care, technology, and cable/telecom sectors.

In the context of the recent market volatility, where might investment managers find opportunity in the short-term corporate bond market? That was just one of the questions tackled by Lord Abbett investment professionals on an April 14 webinar on short duration credit. Director of Product Strategy Stephen Hillebrecht hosted the presentation, which featured Partner and Portfolio Manager for Fixed Income Andrew O’Brien and Investment Strategist Joseph Graham. Here, we present edited versions of their responses to investor questions on short-term corporate credit offered during the session, along with some additional observations. To hear their views on the full range of topics covered in the webinar, please register to access a replay.

1. What are the implications for corporate bonds of the U.S. Federal Reserve’s (Fed) massive expansion of its lending program?

Graham: There were a couple of surprises in the Fed’s announcement on April 9, and they were generally on the positive side, in our view. (Read a full analysis by Investment Strategist Timothy Paulson.)  The first was that the primary and secondary purchase facilities included so-called “fallen angels,” companies that had been investment grade until slipping below the ‘BBB’ level due to recent downgrades. Having the Fed as a source of financing is obviously a positive for those companies that had recently been downgraded from investment grade into the high yield category. But we think it was also good news for current issuers rated BBB, as many market participants were afraid of the effects future downgrades might have on those companies’ access to liquidity. We think that’s been a driving force behind the spread compression we’ve seen in the ‘BBB’ space in the last week. (see Figure 1). We believe the Fed news has been a real lifeline for those companies.

Figure 1. After Widening Considerably, Spreads on BBB-Rated Short Corporate Bonds Have Narrowed.
Spreads on the BBB-rated component of the ICE BofAML 1-3 Year U.S. Corporate Bond Index, March 12, 2010-April 9, 2020

Source: ICE BAML US Corporate Index data. All data as of 4/9/2020. A basis point is one one-hundredth of a percentage point. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment,
and are not intended to predict or depict future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is not a reliable indicator or guarantee of future results.

2.  What has been the overall experience of the corporate bond market during times of elevated defaults?

Graham: In our view, the selling seen in the short term corporate market has been driven primarily by investors scrambling to raise cash rather than real default risk in the near term. Very wide spreads implied substantial default probabilities over horizons we believed companies could survive. That’s what a dislocation is, though, and, in many cases, the utility of having cash on hand outweighed the prospect of owning a good credit for a few months, no matter what the yield.

This is something we’ve talked about with clients extensively: spreads in investment grade corporate bonds are largely compensation for liquidity risk rather than default risk. In figure 2, the solid line shows losses in corporates by rating category in the previous year, calculated by applying a conservative 50% recovery to Moody’s default figures. The dotted lines show average spreads for bonds of particular ratings in each of those years. What you see is that you are very well compensated by spreads for any losses in investment-grade (IG) corporate bonds (bonds rated BBB or above). Even in the depths of the global financial crisis, losses for BBBs did not exceed what investors were being paid for BBB risk prior to the crisis. So this time is likely not to be different, in our opinion. History has shown that IG companies don’t jump to default en masse, even in an economic shock as severe as this one. The impact of such a cascade of defaults to the rest of the financial system would be almost incomprehensible, which is why fiscal and Fed action were so swift this time. That’s not to say there won’t be any defaults; over the course of time there almost assuredly will be, but there will be winners and losers.

Figure 2. Corporate Credit Spreads versus Annual Credit Loss Rates
Historical data for the calendar years 1997-2017 (most recent available)

Source: Moody’s and Bloomberg. Historical data as of 12/31/2017 (most recent data available) OAS=Option-adjusted spread. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment. Subject to change based on changes in the market.

Hillebrecht: We think it’s important to remember that investment-grade companies typically have a lot of financing options at their disposal—for example, reserves, credit lines, and potential asset sales. With a lot of levers to pull, these companies potentially have the ability to stay on a steady financial footing during times of stress, making a fall from investment-grade to default in a short period very rare.

3.  What is the investment team looking at now? Where is it seeing potential opportunities in short-term corporate credit?

O’Brien: In the wake of the pandemic crisis, we are undertaking a fundamental reassessment, trying to figure out which companies are going make it to the other side of this. And how might the environment for corporate issuers look when that time comes?

It’s a two-step test. One, we need to ascertain whether companies have a bridge to help them get to the other side of this economic disruption. You can't assume that “if business picks up in three months, then this company will be okay." We believe you need to make sure the issuer in question has the liquidity to get through those three months. It would be overly simplistic, for example, to just assume a 40% reduction in annual income and make your calculations from there. Instead, we believe that it is necessary to heighten the stress scenario and say, "Let's take their income to zero for three months and see how things look"—and repeat that process for all the issuers under scrutiny.

The second thing we are looking at is the level of support an issuer may have. Does it have access to the Fed programs that have been announced since the crisis began? Does it have a sponsor backing it that is likely to provide liquidity if they need it? Are banks willing to help this particular issuer? We've seen that even in some of the industries undergoing the greatest financial stress—industries that are right at the epicenter of the crisis--there are a number of different responses to bolstering financial strength. I think being an investment-grade issuer means you do have some flexibility in such episodes.

As we look out over the landscape though, and as we think about where we want to be positioned in the coming weeks, months, and quarters, our focus right now in the corporate space is on what we call “secular winners.” We are looking at industries like health care, technology, cable and telecom—businesses that have been less disrupted by the measures to contain the virus and in fact, may actually be in a stronger position because of the way the situation is playing out.

For example, look at the cable industry. People have seen the value of technology, especially as it relates to conducting their business and personal lives on the Internet. Based on industry reports, more people are upgrading their Internet service by choosing more robust cable broadband.

As for health care, I think there will be a lot more government support for the sector. Essential service providers like hospitals that have faced operating stresses in the current environment are likely to get additional help from the government, in our view. That seems to us like it may be another secular winner.

Overall, we believe there are potential opportunities in identifying the sectors that will benefit most as the U.S. economy begins to reopen. In terms of our short duration credit strategy, we think high-quality banks may potentially be among the best places to be. Banks are, in some ways, a levered bet on the strength of the economy just by the nature of their business. And banks should be helped by a recovering U.S. economy—and all the support that the Fed and the U.S. government have provided in terms of liquidity and market functions. We think the larger, higher-quality banks could potentially be in a good position to benefit from these conditions.

Strategies with a more aggressive credit orientation may be worth consideration as the economy begins to reopen—for example, metals producers, home builders, and other building-related businesses. If we have a return to economic growth, and a more stable labor market, we think that should potentially help the housing sector, along , of course, with the very low mortgage rates we’re seeing right now.

To sum up, there will be industries that benefit directly as the economy gets back on its feet, and we will be actively examining opportunities in the sectors we’ve mentioned as that happens. But for the short duration strategy right now, we are focused on issuers in the industries that could be longer-term secular winners, like health care, technology, and cable.