US Investment-Grade Corporate Bond Views—Q1 2021

    Franklin Templeton Fixed Income

    Strong demand is supporting the US investment-grade corporate debt market, as investors continue to seek out investment-grade bonds as a relatively safe source of yield in what is likely to be an extended period of historically low interest rates. This appetite for bonds has allowed issuers to continue to bring record levels of new-issue supply to market, helping companies build liquidity and reduce near-term refinancing risks.

    Corporate bond spreads have rallied significantly in recent months, with the bulk of tightening coming on the back of the US election results and the promising news of an effective COVID-19 vaccine, which mitigated some key sources of uncertainty for the market. Spreads now reflect a more supportive economic and risk outlook going into 2021. We remain generally positive on investment-grade corporate bonds, although we believe the opportunity has become less compelling given tighter valuations and continued near-term macro and policy uncertainty, particularly as new COVID-19 cases surge. We are neutral on the sector over the next 12 months, but we remain comfortable with fundamentals and market technicals. We prefer to focus on select intermediate and longer-duration bonds, including BBB-rated issuers, while taking advantage of new issues or any market dislocations to add exposure to the asset class.

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    Visit Global Fixed Income Macroeconomic & Sector Views: Q1 2021 to learn more about our outlook for each sector.

    The election results are perceived as generally positive for credit markets, assuming the Republicans maintain a majority in the Senate after the runoff elections in the state of Georgia, although divided government might lead to lower fiscal stimulus. The market is counting on a divided US government to limit significant policy changes. President-elect Joe Biden’s regulatory appointments and executive actions will be in the spotlight, particularly as they might impact the energy, health care, pharmaceutical, technology, and financial services sectors. Environmentally focused sectors and companies may benefit from an increased focus on climate change. On the margin, though, we believe that increased regulation will be a negative for corporate profitability and operating flexibility; however, given Biden’s role in the Obama Administration, a reversal to regulatory regimes of just four years ago should be manageable for most companies. Trade relations will also be a factor—particularly with China—although it seems like Biden’s administration will likely continue to take a relatively hard line on trade with China. More normalized relations with other countries might ease trade tensions.

    The Federal Reserve’s (Fed’s) announcement in March of the Secondary Market Corporate Credit Facility and Primary Market Corporate Credit Facility clearly turned the market around from a period of extreme illiquidity. Much of that improvement came just from the announcement effect, as the Fed did not start buying exchange-traded funds (ETFs) until May and individual bonds in June. Actual purchases by the Secondary Market facility have been modest, especially over the past several months, while the Primary Market facility has not been used at all. The presence of the Fed as a buyer of corporate bonds has been an important confidence booster, but the market took in stride recent news that the US Treasury was not extending the facilities beyond the December 31 expiration. Part of that comes from the belief that a Democratic administration may restart the facilities if necessary, particularly with Janet Yellen as Treasury Secretary.

    The economic fallout from the COVID-19 pandemic continues to impact corporate credit fundamentals, as revenues and cash flows have fallen for many companies and a recovery is likely to be slow. Gross leverage at the index level has reached an all-time high. With increased levels of debt and challenged year-over-year earnings, leverage is expected to continue to rise through the first quarter of 2021. However, we can look forward with a level of confidence that these metrics will improve with earnings and more positive economic data as we progress through the year.

    Importantly, issuers have proactively added liquidity cushions or refinanced near-term debt maturities to bolster their financial position. In our opinion, it seems as if we have already begun the balance-sheet repair phase of this credit cycle. Many companies are addressing 2021 and 2022 maturities, and even some refinancing issues from just this past March/April, given the change in overall yields since they were issued.

    The concern around potential “fallen angels” has been top of mind for investors for the past couple of years, given the increase in the BBB-rated portion of the credit universe. Some metrics imply that as much as 52% of the IG Corporate Index could be rated high yield if one considers just elevated leverage ratios. While there is still a considerable amount of debt on negative credit watch by the rating agencies, ratings trends have been improving since April. With an improving economy, cash-rich balance sheets, and a conservative approach to financial management, most investment-grade companies should be able to navigate this more challenging environment. But, we believe active portfolio management, underpinned by intensive credit research, will continue to be an important way to differentiate between winners and losers in the months ahead.


    WHAT ARE THE RISKS?

    All investments involve risks, including possible loss of principal. Municipal bonds are sensitive to interest rate movements, a municipal bond portfolio’s yield and value will fluctuate with market conditions. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. The price and yield of a MBS will be affected by interest rate movements and mortgage prepayments. During periods of declining interest rates, principal prepayments tend to increase as borrowers refinance their mortgages at lower rates; therefore MBS investors may be forced to reinvest returned principal at lower interest rates, reducing income. A MBS may be affected by borrowers that fail to make interest payments and repay principal when due. Changes in the financial strength of a MBS or in a MBS’s credit rating may affect its value. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments. Investments in emerging markets involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size and lesser liquidity. Investments in fast-growing industries like the technology sector (which historically has been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement. Changes in the financial strength of a bond issuer or in a bond’s credit rating may affect its value. High yields reflect the higher credit risks associated with certain lower-rated securities held in the portfolio. Floating-rate loans and high-yield corporate bonds are rated below investment grade and are subject to greater risk of default, which could result in loss of principal—a risk that may be heightened in a slowing economy.

    Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.