We’ve watched a bit of a bear market rally in stocks, but also saw the same short term narrowing of corporate bond spreads (the difference between the yield offered by corporate bonds versus the virtually risk-free government bonds or treasuries). I’ve argued that the stock market rebound in recent weeks was premature, and the corollary to this is that the bond market is also too optimistic.
Corporate debt is at historic levels, fueled by low interest rates since the Financial Crisis. Companies borrowed money to buy-back shares (I’ve published about the shrinking availability of publicly-traded stocks in the past).
During the first stage of the market meltdown, corporate spreads also widened considerably. They narrowed as talk of the potential recovery (V-shaped) was top of news and the ramifications of the global lock-down due to the coronavirus were (and still are) unknown.
What we do know is that the impact on the economies of the world are far worse than expected, and will continue to see surprising news on the downside as data becomes available. The markets shrugged off the unemployment figures, but will be hard-pressed to ignore the pending bankruptcies, and damage to corporate cash flows and profitability economy-wide. The process of ‘adjustment’ of expectations to reality has only just begun.
The sell side earnings estimates are still too high, with consensus forecasting just a 10% drop in EPS, the Citi team adds. PMI data is due for release on Thursday, with expectations of a drop in the flash U.S. manufacturing PMI to 38.5 from 48.5, according to a FactSet-compiled consensus.
On the other hand, top-down analysts are forecasting a hit to corporate earnings as high as 40% to 50%.
As time goes by, a more accurate consensus will evolve (the 1st Quarter earnings won’t paint as accurate a picture – we need to wait for the 2nd Quarter).
If the stock market (as I expect) resumes its decline with the advent of increasingly negative data, then it is inevitable that corporate bond spreads widen again. Despite the quantum infusion of liquidity by the central banks, it will take 12 to 18 months (at least) for businesses to get to the point where they can rely on internally generated cash flows to finance their operations, never mind their historically high debt obligations.
Widening corporate spreads would suggest that bonds aren’t necessarily the safe haven we’d like them to be. Funds and ETF’s dedicated to higher yield corporate bonds (and especially junk bond funds) are at risk. The only safe alternative for the next few months might be cash.
As you can see from the below longer term chart for corporate spreads, it is not impossible for them to widen at times of crises.