The Long and Short
Longer corporates look vulnerable to further selling
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Since the Fed initiated its first rate hike since 2018 at the March FOMC meeting, Treasuries have continued to sell off in what is shaping up to be the worst quarterly bond rout since the early 1970s. The sell-off has been particularly harsh since late February, with the rate on US 10-year Treasuries rising by over 60 bp to its current level of roughly 2.45%. The curve has flattened aggressively during the sell-off, pushing the gap between 5- and 30-year maturities to its narrowest level in 15 years. Longer-maturity corporate debt looks vulnerable.
Exhibit 1. US Treasury Curve and IG Corporate Bond Yields – current vs year-end 2021
Source: Bloomberg LP
Investment grade corporate bond spreads have moved materially tighter since the first rate hike was initiated, and the investment grade index has tightened from a local peak level of 145 bp on March 14 to its current level of 123 bp over the past ten days. Similar to the yield curves, the long-end of the investment grade spread curve has gotten remarkably flat, with the difference between 10-year and 30-year corporate spreads now just over a single bp.
Exhibit 2. IG Corporate Bond Spread Curve – current vs year-end 2021
Source: Bloomberg LP
In addition to the concurrent market pressures, this spread curve flatness is at least partially due to recent supply and demand dynamics in the corporate primary market. Specifically, the aggregate duration of the investment grade index has dropped sharply year-to-date, moving from an aggregate option-adjusted duration of about 8.6 at year-end to its current level of just over 8.0 turns of duration (Exhibit 3). In fact, the measurement has actually moved back to the levels observed immediately prior to the Covid-19 pandemic. The index duration increased rapidly beginning in April of 2020, as corporate borrowers lined up to issue longer-term debt, with the support and back-stopping of US Federal Reserve, in order to firm up their balance sheet liquidity and term out their debt maturity schedules. This led to increased issuance of 30-year debt, which corporate bond investors have been more than willing to accommodate. This behavior from corporate management teams continued until the end of 2021. Since then, longer-dated debt issuance has tapered off as the heightened two-year period enabled most investment grade issuers to term out their debt and improve their capital structures. As a partial result, the current duration of the index appears to have returned to a more normalized level, and some of the pressure that has helped flatten the long-end of spread curve is expected to dissipate.
Exhibit 3. Option-adjusted duration of the IG corporate bond index
Source: Amherst Pierpont, Bloomberg LP, Bloomberg/Barclays US Corp Index
With the Fed poised to begin the dual tasks of continuing to hike rates while simultaneously shrinking its $9 trillion balance sheet, heavy selling in US Treasuries has begun to impact global markets. It seems likely that investors could soon demand higher and higher premiums to hold longer-dated debt, which could spur yield curve steepening off the current levels of historic flatness. Of course, my colleague, Steven Abrahams, has pointed out a range of factors that could further flatten and invert the yield curve. Time will tell.
Fed guidance on asset sales, or quantitative tightening, could come as early as next month when minutes from the March FOMC meeting are released. That could put the beginning of balance sheet runoff plans as early as May. Holders of long-dated investment grade corporate debt could be squeezed as the long end of the Treasury curve sells off in subsequent months. With effectively no spread premium to move out into 30-year corporate instruments, investors should be moving a greater allocation of holdings down the curve ahead of projected selling in long-dated US Treasuries.
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