Cash rules everything around me

The recent strength in US economic data has been good news, and means less risk of imminent recession. But it isn’t making high-quality corporate bonds any more attractive — especially relative to cash.

It isn’t clear why, exactly, corporate bonds are trading at such a narrow spreads over Treasuries. Short-maturity bills, which have no risk of default and are essentially cash (as long as the US doesn’t fumble its debt limit and nuke global markets), yield more than 4.5 per cent. The broad investment-grade bond market pays 5.2 per cent.

One could argue that steady economic growth should help company fundamentals. But the type of economic strength matters for credit, as Barclays argues in a Friday note.

Going by PMI data, the US service sector is growing while the US manufacturing sector is not. In fact, the gap between the two metrics has rarely been this wide, especially at a time when bank credit is contracting, according to the Fed’s survey of senior lending officers.

And in those times — when services are growing, manufacturing is shrinking, and banks are lending less — corporate bonds usually trade at wider spreads to Treasuries. From Barclays:

Spreads appear to be trading too tight in relation to current PMIs and US banks lending conditions. When banks are tightening lending conditions materially and manufacturing PMI is contracting, spreads are usually much wider, even if services PMI is expanding. The late-2000 period seems to be the best historical comparison to current conditions. Investment grade traded at around 180bp and high yield traded around 700bp then (Figure 6).

To compare, investment-grade bonds are trading at a 122-basis-point spread, and high-yield bonds are trading at a 417-basis-point spread.

The manufacturing sector matters more these days, too. Barclays finds that manufacturers make up a greater share of the investment-grade bond index than it did two decades ago:

In all, this doesn’t bode well for corporate bonds.

Goldman Sachs is becoming marginally more bearish on high-quality corporate bonds as well, though for them mostly it’s a matter of the comparison to cash. With our emphasis:

Even if long-dated Treasury yields stay anchored around current levels, we think spreads are increasingly facing binding valuation constraint. This is especially the case for the high end of the IG quality spectrum which has to cope with the re-emergence of cash as a competing and rewarding alternative. As shown in Exhibit 2, the yield pick-up offered by A-rated bonds over the 3-month Treasury bills (a proxy for cash) has virtually vanished. Put another way, until the yield curve re-steepens, credit and duration risk taking incentives will likely reset lower.

Because of this, the bank’s credit strategists downgrade higher-quality bonds (rated A-, A and A+) relative to the lowest three tiers of IG:

Downgrading A-rated bonds to a neutral allocation vs. BBBs (from overweight previously). In early September, we recommended upgrading A-rated bonds to an overweight allocation vs. their BBB-rated peers. Two key ingredients underpinned this view. The first was relative valuations, as reflected in the thin excess spread premium provided by BBB-rated bonds relative to the post-global financial crisis period. The second was the larger exposure of the A-rated bucket to Banks (which account for 44% of the index), a sector that we had been recommending an overweight allocation on. As Exhibit 6 shows, this view has played out, with A-rated spreads materially outperforming their beta to their BBB-rated peers throughout the rally. Where to from here? We recommend shifting back to a neutral allocation.

What about the bonds in the highest two ratings tiers, AAA and AA? Well, it isn’t clear why we (or Goldman’s clients) should care. Combined, they make up less than one-tenth of the index, according to ICE data.