Despite improving credit fundamentals in the banking and financial sector, investment grade bond buyers are getting a spread advantage relative to other sectors.
This is according to Barings portfolio manager Stephen Ehrenberg, who said at a media presentation in Hong Kong that this is creating an opportunity for active bond managers.
“Banks, from a credit perspective, are in much better shape than they were a decade ago,” he said.
It is “a story of improving credit metrics”, he explained, pointing to better bank core equity capital ratios and non-performing loan ratios at 10-year lows.
But despite improving fundamentals over the past decade, spreads in the sector are still higher relative to other sectors, he said.
In some cases, this might be due investors’ aversion to the sector because of the regulatory challenges the sector often faces, but Ehrenberg suggested it might be due to some overlooked technical aspects.
“Many insurance companies have issuer limits,” he said. “When you look at some of the big banks in the US, insurance companies are up against those issuer limits because the US banks are very large issuers.”
“When they hit those limits, if they don’t want exposure to any single issuer at more than 1%, and then they kind of lose their ability to buy banks.”
This lack of demand could be one major factor be one reason why spreads are not as tight for the sector as much as others.
A margin of safety
Elsewhere in the investment grade bond market, Ehrenberg said there has been an overall improvement in the ratings trend.
According to his research, since Covid, the ratio of ratings upgrades to downgrades within investment grade has been improving, reaching a multi-decade high of 4.7 upgrades relative to downgrades last year.
Although spreads are tight, it is somewhat justified in Ehrenberg’s view due to the lower possibility of a mass downgrade cycle as a result of less triple B minus debt in the market.
If economies do fall into recession, Ehrenberg is not concerned because he expects any spread widening will come with a fall in interest rates – which will offset and provide a cushion against capital losses.
“We think there is an appropriate margin for safety in the market now,” he said. “Some of that comes from the yield, some of that comes from that inverse correlation between rates and spreads.”
Additionally, he noted that institutional demand for investment grade bonds more broadly remains strong.
“Last year in the US, we saw over $375bn of inflows into investment grade corporate bonds,” he said. “US life annuity sales have increased dramatically over the last two years, and typically, when annuity providers sell product, they invest a significant portion in investment grade corporate debt.”
He also pointed to pension funding ratios in many developed countries – where ratios have been increasing to well above 100%.
“As a result, many pension plans are now looking to de-risk by selling equities and rotating that into corporate bonds,” he said. “So that’s been another source of demand for corporate credit.”
