In the last three months, market volatility has penalized the bond sector as a whole. Archived for the moment the infinite Greek question, it seems that companies are returning to finance themselves on the markets, after weeks in which new issues were frozen, the calm could return to the credit market.
To date, according to the Bloomberg index, Investment Grade corporate bonds issued in US dollars offer a spread over the interest rate swap curve in dollars of 160 basis points compared to 97 for bonds issued in euros. If, as an indication, we add the spread to the 5-year swap yield (roughly the average maturity of corporate issues) we obtain an average nominal yield to maturity for corporate issues in dollars of 3,10%. If we move to the High Yield segment, the nominal yield rises to 7,0%.
Under current market conditions, Investment Grade dollar issues are discounted by a credit risk of 60 basis points compared to equivalents in Euro, in the High Yield segment the credit risk rises to 177 basis points.
In a low-yield environment, US Corporate yields may push many investors into this asset class. But often greater risks lurk behind higher yields, which is why a European investor must ask himself whether the yield offered rewards the underlying risk scenario.
Let's review the major risks that can weigh on US corporate bonds.
Credit risk: US corporate health looks better, but….
On an aggregate level, the companies making up the basket of dollar bonds (mostly US) enjoy a better financial position than those in Europe. For example, the average interest rate coverage for companies in the US basket is around 17, while for the European one it drops to 10.
However, focusing on US corporate bonds, as we move towards the High Yield segment, the interest rate coverage drastically worsens to the point of eliminating the better financial quality of the issues in dollars. In the High Yield segment, the average 5-year default probability deduced from CDS is three times higher than in the Investment Grade segment (by 1,0%). Although the risk of default is low in absolute terms, the risk should not be underestimated because the market is not always right.
Rate risk: The market appears to be pricing in the Fed's rate hike
If you invest in corporate bonds you are exposed to interest rate risk, and will likely be affected by the upcoming Fed interest rate hike.
Over the last three months, yields on government bonds have increased slightly and to date, the market estimates a first increase in rates in September and a second between December 2015 and January 2016. Considering that yields on the long end of the curve remain lower than the post-Tapering period, the Fed has every interest in ensuring that the rise in yields is gradual.
In conclusion, I have the perception that some of the Fed's monetary normalization is already included in prices, and that the Fed has enough leeway not to destabilize the corporate sector too much. We will see.
Currency risk: the dollar should remain at these levels
Up to now, the exchange rate effect (eur/usd) has contributed positively to the investments in dollars of a European investor. And I believe this trend can continue. In fact, taking into account the overall scenario facing the US economy compared to that of the euro zone, I expect the eur/usd exchange rate to remain at these levels or, in any case, that the appreciation of the euro is unlikely.
On the other hand, the repercussions that the dollar can have on the stock market, penalizing company results, should be kept under control. From what can be deduced from the publication of the second quarter results, the "dollar factor" does not seem to be so penalizing. At an aggregate level, the drop in turnover in the energy sector following the collapse in oil prices seems more penalizing.
All in all, barring large episodes of risk aversion on the horizon, corporate bonds in dollars appear to offer attractive yields and thanks to their large coupons they can offer a valid alternative to those who need to supplement their income. But pay attention to the risks, and in particular to the High Yield segment which, in addition to not offering particular guarantees in terms of financial solidity, has a non-negligible exposure to commodities.
