US Corporate Bonds Outperform Treasuries Amidst Policy Uncertainty

US corporate bonds are exhibiting lower volatility than US Treasuries, defying conventional wisdom and potentially signaling a shift in investor sentiment, Bloomberg reports. This unusual dynamic is driving high valuations for company debt.

In a recent analysis, Barclays Plc found that, on a six-month rolling basis, investment-grade bond yields have been less volatile than US government debt, a trend that has intensified since the November election.

While US Treasuries are typically considered the safest securities, recent economic uncertainty and conflicting policy signals are prompting some investors to reassess their risk perceptions.

"Trying to accurately discount the fiscal policies or broader policies of the US government is next to impossible right now," said Michael Brown, senior research strategist at Pepperstone Group, to Bloomberg. "Whereas when you're trying to discount the outlook for a corporate, it is somewhat easier to make a more high-conviction call."

The US Treasury market has experienced significant turbulence following President Biden's re-election. The yield on the 10-year Treasury note reached a high of 4.8% in mid-January, fueled by concerns over resurgent inflation. However, these concerns have since eased, leading to a decline of approximately 50 basis points in the yield, as investors fear the administration's economic policies may stifle growth.

This shift has driven investors towards corporate bonds, where yields have remained above 5%, pushing valuations to potentially elevated levels. The premium investors demand for holding US high-grade corporate bonds instead of comparable government debt has hovered near the lows last seen in the lead-up to the 2008 financial crisis, according to Bloomberg-compiled data.

The relative stability of investment-grade corporate bonds is also reflected in the equity market. According to Morgan Stanley research, a 1% fluctuation in the S&P 500 Index this year has corresponded to a mere 1 basis-point change in a Markit measure of perceived credit risk, down from an average of 2 basis points over the past decade.

Historical patterns suggest that periods of subdued volatility in the investment-grade bond market often coincide with significant inflows of capital. Data confirms this trend, showing continued strong inflows into mutual funds and ETFs tracking high-grade bonds, accelerating in the week ended February 26th.

Analysts and money managers remain optimistic about the outlook for high-grade credit, citing a favorable economic backdrop characterized by moderating inflation, robust job growth, and strong earnings, particularly in the banking sector.

"It's this not-too-hot, not-too-cold environment that we see that's been supportive for IG credit," said Jon Curran, head of investment grade at Principal Asset Management.

However, some investors question whether historical data is an appropriate benchmark, given the evolving structure of the market.

Christian Roth, chief investment officer of global fixed income at Northern Trust Asset Management, points out that default risk represents only a small portion of the overall spread in the investment-grade market. The rest is attributed to the lower liquidity of corporate bonds compared to government bonds. But with the increasing adoption of electronic and portfolio trading, the high-grade market is becoming more liquid, potentially altering historical norms.

"We are seeing a secular narrowing of credit spreads," Roth stated. "Maybe the historical long-term average is the wrong benchmark."

Despite this optimistic outlook, recent widening of credit spreads, driven by falling Treasury yields, has raised some concerns. This trend, potentially triggering "sticker shock" among investors, may persist until greater certainty emerges regarding tariffs and their impact on businesses and consumers. However, analysts like Hans Mikkelsen of TD Securities view this as a temporary hiccup, emphasizing the underlying strength of the US economy.