Andrew Sheets: The Rise of Corporate Bond Yields

September historically has been a big month for corporate bond issuance, but borrowing looks less attractive to companies due to the large rise in yields.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Corporate Credit Research for Morgan Stanley. Along with my colleagues bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, September 22nd at 2 p.m. in London.

Credit has outperformed equities recently, with spreads modestly tighter, even as stocks are modestly lower. We think that credit outperformance continues. Supply, demand and income are all part of the story.

September is usually a big month for corporate bond issuance as people return from the summer, and all that supply often means somewhat weaker credit performance. But so far, that supply is underwhelmed. While many factors may be at play, we think one is that borrowing is looking less attractive given the large rise of corporate bond yields.

Not only are investment grade bond yields at some of their highest non crisis levels in the last 20 years, they're unusually high relative to the earnings or dividend yield offered on company stock. Now, if a company views their equities attractive relative to debt, one way they can express this is to borrow more while buying back or retiring those shares in the market. But conversely, if companies start to view borrowing as expensive, relative to their shares, borrowing and buybacks should both slow. And year-to-date that's exactly what we've seen from non-financial investment grade companies.

Meanwhile, those same higher yields that are making companies more reluctant to borrow are keeping demand for bonds solid. And if both the Federal Reserve and the European Central Bank are now finished raising interest rates, as my colleagues in Morgan Stanley economics expect, it could mean that investors are even more willing to allocate to these high grade bonds, while simultaneously encouraging companies to display even more patience with borrowing now that rates are no longer rising.

But there's another even more mechanical advantage that credit enjoys. The significant rate hikes from the Fed, and the European Central Bank have meant very high yields on safe short term cash. That, in turn, has made the cost of holding almost any asset more expensive by comparison. Due to these very high cash yields and the fact that short term interest rates are higher than long term interest rates, owning equities or government bonds in the U.S. and Europe is a so-called negative carry position, costing money to halt. The passage of time if nothing changes, is currently working against many of these asset classes.

But this isn't the case in credit, where both the level of spreads and the shape of the credit curve mean that the passage of time works in favor of the holder. And it's worth noting that two other assets that have this so-called positive carry property, the U.S. dollar and oil, are also currently being well supported by the market.

We think the Federal Reserve and the European Central Bank are now done raising interest rates for the foreseeable future. We think this could modestly discourage borrowing by investment grade companies as they wait for more favorable rates and encourage buying as investors hope to now lock in these higher yields. Moreover, we think that this pause by central banks could help reduce overall bond market volatility, working to the relative advantage of assets that pay investors to hold them like corporate credit does.

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