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In the sweet spot with investment grade corporates

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      By Bernard Scozzafava, CFADirector of Investment Grade Fixed Income Quantitative Research, Eaton Vance Management

      Boston - Up almost 13% through September 30, investment grade (IG) corporate bonds as measured by the ICE BofAML U.S. Corporate Index have enjoyed their best year-to-date (YTD) total return since the current credit cycle began in 2009. While 2020 is unlikely to bring a repeat of this impressive performance, we believe that the sector continues to offer good value.

      Positive supply-demand technicals, healthy credit fundamentals and attractive valuations relative to other investment choices all contribute to our favorable outlook for the sector. Although each of these factors has generated negative headlines recently, our analysis suggests that they will remain supportive of the asset class over the coming year.

      Positive supply-demand technicals

      September is usually a month of high issuance as traders and investors return from their summer holidays and liquidity improves. Coming off particularly slow issuance this August, as the sharp decline in equity prices and the rise in credit spreads discouraged companies from bringing new deals to market, the first week of September set a record for weekly issuance.

      Despite the resulting concern that an ongoing avalanche of supply would push spreads wider and prices lower, the jump in issuance proved temporary, followed by five consecutive weekly declines in supply. In fact, issuance has been muted so far in 2019. Even after accounting for that surge in early September, gross supply at the end of the third quarter was still roughly 1% below levels at that same point in 2018.

      Recognizing that not all supply is new supply, we can also compare net supply. Removing redemptions and maturities from the gross issuance number leaves net issuance YTD in 2019 20% less than net supply through the third quarter last year.

      As a sign of the market's health, demand for the new issues has been robust, and most issues have traded up in the secondary market. IG corporate bond demand is more challenging to measure than supply. As a proxy, we monitor flows into broad IG fixed income mutual funds and exchange-traded funds (ETFs).

      The combination of lower rates and tighter spreads has created YTD returns that have attracted investors to investment grade fixed income. With the extraordinarily low — and in many cases negative — rates internationally, non-U.S. buyers have also shown more interest in relatively higher yielding U.S. corporates. According to Wells Fargo, demand for IG mutual funds so far in 2019 has been roughly double what we saw in 2018 and similar to the record flows in 2017.

      Healthy credit fundamentals

      The amount of debt that IG companies have issued relative to the amount of cash they generate — that is, their leverage ratio — has steadily increased over the last few years. As reported by Morgan Stanley, gross leverage, at 2.9 times, remains higher than at past cycle peaks, raising concerns that this ratio may rise further as economic growth appears to be slowing.

      However, just as it makes sense for individuals to refinance their mortgage loans when rates fall, corporations can also take advantage of the favorable rate environment to retire or call existing debt and issue new, longer-maturity debt. These new issues lock in lower rates for longer periods, helping to improve the issuer's overall ability to service its debt.

      With the cost of borrowing reduced, interest coverage for the ICE BofAML US Corporate Index, at 12 times, more than offsets the higher leverage. In our view, corporate fundamentals are reasonable, while also clearly indicating the late stage of the current credit cycle.

      Attractive relative valuations

      During 2019, falling rates and narrower credit spreads have driven double-digit returns across many fixed income sectors, including IG corporate bonds. Unlike lower rated bonds, IG corporate returns were primarily powered by rates.

      As a result, the yield advantage that IG corporate bonds offer over U.S. Treasury notes has declined to 117 basis points (bps) — slightly under the pre-crisis average of 127 bps through December 31, 2007, and a little better than the post-crisis lows of 90 bps in early 2018. The yield pick-up is even greater against many non-U.S. developed market sovereign and corporate bonds.

      We don't anticipate material spread tightening from here. Nevertheless, we think IG corporates offer good value considering their historically low default rate.

      Bottom line: With their low default and downgrade risk, IG corporate bonds have tended to provide a solid balance between yield and safety. We believe technicals, fundamentals and relative valuations should continue to bolster this market going forward.