Calm Corporate Bond Market Shows Everything Is OK, Says LPL

Sure, stock indexes are at record highs, and their lofty valuations evoke scary memories of other times when investors were beset by foolish optimism. And atop that is the threat of inflation. But there’s one place that is signaling all is well and that calm seas will prevail. That would be the corporate bond market.

“Corporate credit markets continue to tell an encouraging story about the economic recovery,” wrote Lawrence Gillum, LPL Financial’s fixed-income strategist. The strength of the $10.7 trillion US corporate bond market is a positive marker for both equity and debt markets, he contended in a research note.

Last year, both investment grade and junk-rated companies issued more than $2.3 trillion in debt, one of the biggest years ever to float bonds, he pointed out. The trend continues. This year through the first quarter, issuance is up 7.6% from the comparable period the year before, according to the Securities Industry and Financial Markets Association (SIFMA).

The option-adjusted spread between corporates and Treasurys is tight, indicating that bond buyers are feeling optimistic—because they don’t need much extra yield above risk-free government paper. The spread for high-yield corporates, for instance, is a tad over 3 percentage points. Last September, it was 5.6 percentage points. During the worst of the pandemic financial panic, the gap was around 10 percentage points.

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Bonds, Gillum observed, tend to “lead markets lower during market stresses.” Now, however, the lack of corporate fixed-income volatility “is a good sign for equity investors, as well.”

The “well-behaved” corporate spread data shows that borrowing costs are low for businesses, he said. The falling cost of borrowing “suggests the corporate sector is in good shape,” he added. An added reassurance comes from how robust corporate balance sheets are, he maintained.

And Gillum noted that all this comes amid higher volatility in the Treasury market. The yield on the benchmark 10-year Treasury hit 1.48% on Tuesday, down considerably from its peak this year of 1.74% in March.

What could up-end the placid picture for corporates? Gillum said the volume of mergers and acquisitions (M&As), stock buybacks, and dividend increases—all of which sap company coffers—“could push spreads higher.”

Nonetheless, LPL is neutral on investment grades and less optimistic on junk. And he stated that stocks offer more upside for the rest of 2021, an unsurprising call due to fatter projected earnings, which always are a tonic for equities.

One factor he didn’t mention, yet could have: The market’s outlook for inflation remains tame, with the five-year breakeven rate at 2.46%. That measure, of course, is what Treasurys and Treasury inflation-protected securities (TIPS) imply. Inflation, as the archenemy of bond prices, would be an unwelcome intruder on the healthy status quo the financial world is enjoying now.