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Jeff Meli Brad Rogoff

Episode 36

Jeff Meli in conversation with Brad Rogoff

Are corporate bond valuations disconnected from fundamentals?

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Corporate bond market conditions are making some question whether valuations have become disconnected from companies’ underlying fundamentals. Valuations are near record highs, while corporate credit ratings, quality and yields are very low - yet investors seem confident. What’s going on?

In episode 36 of The Flip Side, Jeff Meli, Head of Research, and Brad Rogoff, Head of Credit Research and Strategy, debate whether traditional measures of corporate bond value need a rethink due to current market conditions. They also discuss how other factors, such as corporate tax rates, inflation, liquidity and intervention by the Federal Reserve, are affecting corporate bond markets both now and over the long run.

  • Jeff Meli: Welcome to The Flip Side. My name is Jeff Meli. I'm the Head of Research at Barclays. I'm joined today by Brad Rogoff, who's the Head of Credit Research at Barclays. Thanks for joining me, Brad.

    Brad Rogoff: Well, thanks for having me, Jeff. And, look, thanks for having me when credit is yielding two percent. I was worried you wouldn't want to talk to me.

    Jeff Meli: Yes. You'd think it's not the most exciting asset class right now. And, actually, that's what we're going to focus on, is corporate bond valuations which are quite high, close to the highest we've ever seen. In fact, after you adjust for credit ratings which are lower, meaning worse, today than has historically been the case, corporate bond prices are actually at all-time highs.

    That means that the yields which what you are talking about, the interest that an investor actually earns from owning a corporate bond, are very low and that's true both in absolute terms and relative to the yields of government debt.

    Brad Rogoff: Not only are the yields low, but most corporate bond investors I speak to are actually pretty sanguine about valuations. And I can't believe I'm saying this but I think the attitude is justified.

    I don't believe that current prices actually are divorced from fundamentals in a meaningful way. As a result, I think the risk of a sharp decline in the corporate market, they're pretty limited particularly given our economic forecast.

    Jeff Meli: Well, Brad, I disagree. At least according to the traditional guideposts we use, both low yields and all that investor confidence look hard to justify – credit quality ratings, liquidity, all of these are worse than average and that should translate into higher yields.

    I think current prices reflect explicit and implicit support that the Federal Reserve has provided to the corporate bond market. In the latter, that implicit support in particular is underappreciated and it could have meaningful long-term changes to the yields that large corporations pay when they borrow money.

    Brad Rogoff: But let me start with why I think valuations are aligned with fundamentals. So, the key issue is your reference to the – I'm doing air quotes here – traditional guideposts. The world's changed in ways that have rightfully reduced the sensitivity of corporate bonds to the traditional measures of value.

    So, for example, we need to rethink an important fundamental measure – leverage. Leverage is the favorite metric of credit analysts, the first thing you learn about when you become a credit analyst. So, what we do is we measure the debt of a corporation relative to its profitability.

    Obviously, a large and highly profitable company can afford to have more debt than a small company that's losing money, say. So, to account for this, we look at the ratio of the total debt of a company and we look at that versus EBITDA, its earnings before interest, taxes and depreciation.

    Jeff Meli: Now, clearly, a higher ratio indicates more debt relative to the profitability of the company. And those ratios are currently high.

    So, to put some numbers on it, look at investment grade companies first. The historical average is close to two. That means companies usually have about twice as much debt as their annual earnings. Right now, that ratio is close to 2.7.

    High yield companies are obviously riskier in general, meaning they have more debt. On average, historically, they would have about five times their EBITDA in debt. Right now, that ratio is closer to six times. Those are meaningful differences. And I'd expect the opposite if you just look at where yields are.

    Brad Rogoff: OK. Well, one obvious issue – I'm not going to debate your facts, obviously, on where those numbers are – is that earnings from many companies temporarily, during the COVID pandemic, declined significantly. They're now rebounding. So, the backwards-looking estimates of leverage aren't really all that informative of forward-looking credit quality.

    Jeff Meli: Look, sure, earnings did fall during the pandemic. But in most industries, they really didn't decline that much. And by and large, they've now fully recovered.

    So, at this point, I think the bigger influence on leverage is all the debt that companies have been issuing. 2020 set a record for corporate bond debt issuance and this year will likely surpass it in certain parts of the market.

    Brad Rogoff: There is a reason to actually have me on The Flip Side, right? The amount of corporate debt just keeps growing and keeps becoming a more relevant asset class. I joke.

    But more seriously, to respond to your question, I want you to first remember that gross issuance doesn't tell the full story when you think about whether those records actually translate into more leverage. So, the net issuance, the amount of debt issued less debt repaid, is a better indicator. And that's not at alarming levels the same way, I agree, gross issuance is.

    So, what's actually more important is the measure of profits you are using and that was EBITDA. And that's the earnings before – emphasis added on purpose – interest and taxes. But companies pay interest and taxes so the money left over is what is really available to pay off debt and that's what we care about as credit investors.

    Both interest and taxes are very different today than in prior times. Interest is lower because interest rates have been lower since the great financial crisis. And by this point, companies' old debt has largely matured and most of the debt stack reflects these lower rates.

    Jeff Meli: Now, the change in interest rates is pretty remarkable, Brad. So, to put some numbers on it, in investment grade, the typical coupon on an investment grade bond right now is only 3.7 percent. Go back 10 years, it was 5.4 percent. And that is a big change in the cost associated with carrying debt.

    However, one of the biggest risks we see and the subject of the prior episode of The Flip Side, is a rise in inflation. That would obviously come with higher rates which means all this reduction in interest expense could be temporary.

    Brad Rogoff: Companies typically refinance when their debt matures. So, it takes a while for changes in interest rates to be reflected in the average interest paid. So, just like it took 10 years of low rates to reduce the coupons to where they are today, it would take a long period of higher rates to raise them over which time companies can adjust in other ways.

    And one thing I might add that I think is particularly relevant here is the average maturity of investment grade corporates has actually never been higher at over 12 years.

    Now, the other big change is taxes. So, the Tax Cuts and Jobs Act of 2017 passed and that substantially reduced the corporate tax rate from 35 percent to 21 percent. Again, that means the same earnings before taxes translates to more money kept by the company and thus, more debt they can afford to carry.

    Jeff Meli: Now, one caveat to those numbers is that very few corporations paid the full corporate tax rate because of all the deductions that get built into the corporate tax code like for interest, investment, et cetera.

    Brad Rogoff: I agree, most corporates were not paying 35 percent exactly prior to 2017. But they also aren't necessarily paying 21 percent today. And the magnitude of the drop which is similar is to me what matters the most.

    Now, obviously, we're talking about the average company when I make those statements, but it's a fair point that for some, the magnitude is not going to be as great.

    Jeff Meli: All right. Now, let's think though about the gains from the tax rate. Those could revert a lot more quickly than the gains from lower interest rates. In fact, there's talk in the Biden administration of raising the corporate tax rate to help pay for some of the ambitious spending agenda. That could change with one stroke of a pen.

    Brad Rogoff: That's definitely a risk. But corporate taxes are likely to rise only modestly, maybe to 25 percent. So, many of the gains will remain.

    So, if we put this all together, we think that an investment grade company can handle a full extra turn of leverage. Maybe it's only 0.9 instead of a full turn if taxes increase modestly. But you look at that versus a decade ago and you look at high yield, we think you can be 0.75 turn higher, you make those adjustments and it brings current leverage much closer to the historical averages.

    Jeff Meli: Well, corporate bond investors also typically get paid a liquidity premium. And they earn that because corporate bonds are less liquid than other fixed income instruments, notably government bonds.

    Now, right now, the liquidity premium in corporate bonds, which we measure in a bunch of ways like comparing off-the-run to on-the-run bonds, for example, is extremely low. Normally, that would indicate that liquidity was strong. But, actually, liquidity of individual corporate bonds remains low, more or less like it's been since the global financial crisis.

    There's a long list of reasons for the decline in liquidity in corporate bonds like bank reform, changing market participants, et cetera. But the net effect is pretty clear.

    Brad Rogoff: All right, Jeff. Well, actually, I'm going to back to your own research that you've done over the past several years. And what you've shown is that investors have developed new tools to manage liquidity.

    And, I think, the best example is actually in high yield, where many mutual funds facing inflows and outflows from their investors now use high yield ETFs. Those trade actively in the market. And they manage those flows rather than relying on buying and selling of individual bonds.

    Jeff Meli: Well, Brad, I'm not going to argue with the conclusions of my own research. We have actually shown that this substitution into ETF trading is occurring to such an extent that it actually further reduces the liquidity in the single-name market.

    Brad Rogoff: Right. But it also means that investors no longer need to rely exclusively on single-name liquidity. And if they don't need it, they won't demand a premium for it. So the price of liquidity can fall even if liquidity is worse.

    Given all the new trading strategies being deployed, I think the liquidity premiums in corporate bonds should be low, which I think it is now clearly as we've said. And it will stay there.

    Jeff Meli: All right, Brad. You focused on some of the typical considerations for corporate bonds. I think the overall downside for credit is being artificially capped as a result of explicit and implicit action from the Federal Reserve. And that is more responsible than all of the typical sorts of considerations that we have. Now, the explicit support for the market is easy to see. It comes in the form super accommodate monetary policy, low rates, and massive asset purchases by the central bank.

    The Fed is keeping rates at zero and buying assets like treasuries and agencies. And so investors don't have a choice. They have to buy risky assets and prices go up as a result. Now, in that sense, you could say that what's happening in corporate bonds is similar to some of the difficult to understand price action in bitcoin or cryptocurrencies or certain meme stocks or even parts of real estate.

    Brad Rogoff: All right. Well, I think I'm pretty smart on credit, but I'm certainly not a crypto expert. But I do think I could say that one important difference between credit and cryptocurrencies is that bonds have a fundamental value. So that means that cash flows can be estimated and priced. And so the potential diversion from reality is much more limited.

    Jeff Meli: Look, I certainly agree that the extent to which an asset could be affected by quantitative easing and low rates varies greatly across assets. And maybe credit isn't being propped up as much as others, but as inflation emerges as a legitimate risk factor, these benefits to corporate bond prices could be at risk.

    I'd also say that it's always sort of a warning sign to me when we're forced to rethink decades-old valuation metrics just to make sense of current prices.

    Brad Rogoff: Well, as I said earlier, we need to no worry so much about our traditional metrics, so that works for me. But on the inflation front, first, I'd point out that although inflation surge is certainly at risk; it's not our base case scenario. And if anything, the risks have receded somewhat, it looks, say over the past few weeks. Second, I thought I told a pretty convincing story about those old metrics.

    Jeff Meli: Yes, it wasn't bad. It wasn't bad, but I actually think that the implicit support for the corporate bond market matters more than the explicit support. I want to focus on that.

    So recall that at the height of the COVID-induced market volatility, the U.S. Federal Reserve announced two new programs to support the corporate bond market, a primary and a secondary market facility that was able to buy both newly issued bonds or existing corporate bonds respectively. And not coincidentally, the day that they announced those programs marked the low point for credit valuations during the pandemic.

    Brad Rogoff: Right. And I suppose this is implicit support, because those programs never ended up being utilized to any real extent; 14 billion of corporate bonds and ETFs were purchased versus 120 billion a month that's still being purchased in treasuries and agencies. It's really just testing the pipes as opposed to actually buying assets. And the Fed just announced that it was unwinding the limited purchases that were made in credit.

    Jeff Meli: Yes, because those programs were never really utilized, I think the effect of them is greatly underappreciated. I think the Fed said a very important message to the market. When the crisis started, credit yields rose sharply. Then the Fed steps in, and that's a catalyst for yields to very quickly reverse those increases. It was almost instantaneous. And the message was if corporate bond prices fall too much, we'll step in and buy them.

    Now, the downside matters a lot when you think about prices of credit or really any fixed income. These aren't stocks, so it's not like the prices could just appreciate without end. The most you can get back is the initial principal plus interest.

    And so, it's really the downside considerations that’s a big driver of prices. But the Federal Reserve basically eliminated any chance of a real selloff. So not only did prices recover, but corporations were able to issue a massive amount of debt at very low yields because investors knew that there was just not that much they could lose when they bought at those prices.

    Brad Rogoff: I mean that seems like a successful program to me. I mean, you're saying in the midst of the crisis, the Fed was able to convince investors that they wouldn't let the system collapse so much so that the central bank didn't even have to put up any money. I mean, if you're the central banker, don't you love when words speak louder than actions?

    Jeff Meli: Yes, I accept that. Investment grade companies would have been able to issue debt anyway. These are the largest, most profitable companies in the world. They can raise money in virtually any environment.

    And we saw that in the global financial crisis, which was far more long lasting in terms of the economic and market damage. At far higher yields, investment grade companies had access to the market. They just had to properly compensate investors. Now, the Fed takes away the risk and these same large profitable companies can issue at very cheap levels. It's a massive value transfer from investors to corporations.

    Those corporations should have had to pay large sums to lock in the liquidity that they thought they needed to survive the pandemic and instead, they had to pay what's going to go down in the records as the lowest yields ever.

    Brad Rogoff: You're speaking about these facilities though with the benefit of hindsight. We know now that the economy wasn't going to collapse. We didn't necessarily know what was going to happen with vaccines to get us to the point we're at today, so maybe we could have let market forces play out, certainly a possibility.

    But we certainly didn't know that at the time. And also remember, the Fed kept their bond purchases to less than five-year bonds that were investment grade rated before the COVID-related shutdowns, in an attempt to signal the main goal was to make sure high quality companies could roll over near-term debt rating if they could issue eventually during the height of uncertainty.

    Jeff Meli: I'd argue that the benefits of lower rates and quantitative easing at least had a chance to be sufficient. These corporate facilities were different. They targeted a very specific asset class and managed to save corporations a huge amount of money with very little official outlay from the Fed as you noted.

    Now, I think on top of that, these programs convinced investors that the tail risks in these asset class don't really exist. I think that's a major contributor to the cheap borrowing rates for corporates today.

    If anything really serious goes wrong, now there's an expectation that the Fed will step in and cap the downside.

    Brad Rogoff: Well, tactically, maybe I'll concede you have a point there since it will only help my argument that lower interest rates make corporates safer than they used to be. Isn't the end result the same anyway?

    Jeff Meli: It is. But I think that there's a difference between safety that arises organically like from low interest rates or conservative management of balance sheets and safety that's provided by the official sector to a specific part of the economy.

    Look, if I am right, this is a pretty big distortion to markets. And I don't think that most people would suggest that the largest, most profitable companies are a particularly worthy recipient of that kind of support.

    Now, it also creates the possibility of even worse volatility if the expected support doesn't materialize during a period of volatility. So, for example, if there is an inflation scare, then the Fed and other Central Banks are going to be trying to withdraw accommodation, tamp down inflation. They won't be able to give additional support the corporate bond market even if it's experiencing severe volatility.

    Brad Rogoff: Well, ideally, we won't test that last prediction anytime soon, as I for one am still coping with trying to get out of this crisis.

    Jeff Meli: Well, Brad, I certainly hope you're right on that front.

    Now clients at Barclays can read our latest research on how to interpret corporate leverage in “Leverage Doesn't Mean What it Used To” and our latest take on central bank accommodation in our recent global outlook entitled "A Grind Higher," both available on Barclays Live.

Authorised clients of Barclays Investment Bank can log in to access related reports on Barclays Live:

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About the analysts

Jeff Meli is Head of Research within the Investment Bank at Barclays. Jeff joined Barclays in 2005 as Head of US Credit Strategy Research. He later became Head of Credit Research. He was most recently Co-Head of FICC Research and Co-Head of Research before being named Head of Research globally. Previously, he worked at Deutsche Bank and JP Morgan, with a focus on structured credit. Jeff has a PhD in Finance from the University of Chicago and an AB in Mathematics from Princeton.

Brad Rogoff is Head of Credit Research and Strategy at Barclays. He and his teams cover corporate bonds in the US and Europe, as well as emerging market credit, municipals and securitized products. Brad assumed management responsibility for the Emerging Market Corporate Credit Research team globally and, in 2018, his role was expanded to include the Developed Market Credit Research team. Brad joined Barclays from Lehman Brothers in September 2008, where he was a member of the Credit Strategy team focusing on high yield bonds and derivatives. He joined Lehman Brothers in 2002 as a member of the High Yield Research team focusing on the media sector and moved to the Credit Strategy team in 2005. Brad has an AB in economics from Harvard University and is a CFA charterholder.

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