As of the end of May, intermediate corporate bonds yielded close to 4% and the spread on the Bloomberg Intermediate Corporate Index was at 112 bps, in the 60th percentile versus history, dating back to January 1990. This looks like the sweet spot of the curve to me, given that investors are not yet compensated enough to extend duration due to the uncertainty that remains with respect to inflation and with the yield between intermediate and long corporates historically narrow. Intermediate corporate yields would need to rise by 89 bps over one year to generate a negative total return. This compares to a 30 bps cushion a year ago. Said another way, income for intermediate corporates today is far more attractively priced than it was last year.
Corporate fundamentals remain strong
Corporate leverage declined in 2021 as companies paid down debt incurred during the pandemic and EBITDA recovered. Despite all the volatility this year, it’s important to note that corporate balance sheets came into the year in a very strong position, which can help to weather the storm. I do expect M&A and shareholder-friendly activity to pick up this year, which could lead to a modest deterioration in fundamentals. But I think most companies, having just experienced the effects of the pandemic, are aware of the importance of a strong balance sheet. It seems likely that the bulk of M&A activity would be executed in the context of maintaining current ratings, though there may be some exceptions.
In this environment, I think there’s a case for being more selective in industrials and favoring financials and utilities. Industrials appear more likely than financials and utilities to be opportunistic in the use of their balance sheet. US bank credit profiles have become more defensive over time, given the rise in regulatory oversight, and I think they’re likely to exhibit more stable fundamentals as a result. I also expect utilities to behave defensively in an economic slowdown. Both utilities and financials are trading at attractive levels compared to industrials on a historical basis. I am less concerned about the vulnerability of banks to a recessionary environment compared to the global financial crisis, given higher capital requirements for the sector.