Trump should sharpen appeal of US corporate bonds

With US Treasury yields rocketing more than one percentage point from a low of just over 1.3 per cent in July to 2.57 per cent, investors are naturally asking if there is any value to be had in owning US fixed-income assets.

It is a tenuous question indeed for government bonds, with Treasury yields set to go higher in 2017. But, for those active in the investment grade corporate market, there are opportunities to earn positive returns over government bonds. The combination of a narrowing credit risk premium and positive carry are poised to generate relative outperformance.

In previous rising rate regimes, corporate bonds have tended to outperform government bonds. Often these periods of rate increases have coincided with a positive return for equities as well. This is not to say investment grade corporates will always generate positive returns while government returns are deeply negative — but the spread compression and additional interest you receive from owning corporates can help to provide a return buffer in a portfolio.

Investors may be souring on bonds in general, but there are two chief reasons to be constructive on the US investment grade market. There is a potential for deteriorating corporate fundamentals to improve, and a positive supply-demand dynamic.

Corporate fundamentals have been on the downswing since 2011. Uninspiring top-line growth, coupled with debt-funded share repurchases and mergers and acquisition activity, has driven leverage to extremes in some industries. Yet green shoots signalling improvement are emerging. In recent quarters the pace of growth of corporate debt has slowed, while growth in revenue and earnings before interest, tax, depreciation and amortisation has turned positive.

The outlook could be even rosier depending on initiatives from the new Trump administration and Congress. If fiscal stimulus fuels a small bump in baseline economic growth, companies sensing better organic growth opportunities could lead to less appetite for debt-funded share repurchases that have bolstered equity prices.

Corporate tax reform could provide an additional fillip, not only in the form of generally beneficially lower rates, but also with respect to the effect on technology and pharmaceutical companies holding sizeable cash balances offshore. This accumulation of cash outside of the US has coincided with high debt issuance from both sectors.

Although partially linked to M&A activity, a large part of the issuance at very low yields has been used to fund share buybacks. By shrinking the tax penalty on these overseas balances, the attractiveness of selling bonds may wane, thereby improving leverage metrics for companies.

The effects of any tax reform are ultimately linked to the supply side of the “technical picture” for the corporate bond market. If the deductibility of interest payments on debt is indeed enacted by the Trump administration, as has been speculated, it could lead to a meaningful decline in new corporate bond supply in coming years.

Even in the absence of such reform, supply in 2017 will be lower. The pipeline of M&A deals is 50 per cent lower now than it was at the end of 2015. And next year will be one in which maturing debt increases by roughly $100bn. Investors should expect a net reduction in supply compared with the record year we had in 2016.

Will retail investors who were so keen on corporate bonds in 2016 go on a buyer’s strike in 2017? Cumulative high grade mutual fund inflows exceeded $60bn. However, with the rate outlook having shifted from lower for longer to reflation the jury is out.

Mutual fund investors are an important part of the demand equation, but foreign buyers who are less sensitive to unrealised losses from higher bond yields may tip the balance of power in the corporate bond market today.

Faced with negative or at best zero yields at home, these investors are drawn to the US corporate bond market. And while the costs of foreign hedging have increased, moving longer on the maturity curve or down in credit quality provides a highly attractive investment alternative to Japanese or core European government bonds.

In a world of higher growth and rising yields, US investment grade corporate bonds stand to benefit. Better fundamentals and the potential for attractive returns versus more duration sensitive parts of the bond market should keep investment grade corporates in demand in 2017.

Lisa Coleman is global head of investment grade corporate credit at JPMorgan Asset Management