The hidden value in corporate bonds

Since late March, US investment grade corporate bonds have recovered approximately 80% of their Covid-driven spread widening. Corporate bonds spreads now sit at about their ten year average of 150 bps over Treasuries, which to some investors appears extremely expensive given the fall in economic growth. The BMO Multi-Asset Solutions Team increased exposure to corporate bonds in April and despite the spread tightening still maintains an overweight position. Central bank policy underpins this view.

We believe the Fed has effectively backstopped the corporate bond market through both words and actions.  In our view, the two most impactful dates for the Fed’s intervention were March 23rd and April 9th. First on March 23rd the Fed announced sweeping new programs, which included purchasing investment grade corporate bonds in both the primary and secondary market. On April 9th the Fed announced an expansion of their purchase program, which would include the debt of “fallen angels” (companies downgraded to junk status post-Covid) and high yield ETFs. These programs helped restore order to the corporate bond market and greatly lessened the credit strains on companies, which were able to re-enter funding markets at reasonable interest rates.

Most importantly for investors, the Fed’s swift action provided confidence that they stood ready to defend the corporate bond market and not let spreads widen significantly over the coming period. From an options perspective, the Fed has written investors a “put” option on their corporate bond holdings. Should liquidity deteriorate or economic conditions worsen, the Fed has demonstrated their willingness to buy bonds from investors and ensure funding costs do not spike again. Conversely, should the economy return to growth and credit risk diminish, the Fed may be a small buyer in the market but investors will reap the rewards of tightening bond spreads.

In keeping with this options framework, we have attempted to value our Fed put option as corporate bond holders. This calculation is not meant as a definitive valuation tool but rather a means to understand the importance of Fed intervention.  In order to approximate the value of this put option there are a few key assumptions for a Black-Scholes options model:

  • Strike price. This is the value at which we think the Fed will step into the market and ensure further spread widening does not occur.  We know the Fed intervened on two key dates as noted above. Before the Fed announcement on March 23 corporate bonds spreads were 363 bps and before the April 9 announcement spreads were 253 bps. So rounding up we can conservatively estimate the Fed’s strike price was 400 bps from March 23 through April 8 and 300 bps from April 9 through now.
  • Implied volatility. Luckily there is a corporate bond ETF with an active options market: iShares iBoxx Investment Grade Corporate Bond ETF (LQD). Using this options market we can derive the overall implied volatility on the corporate bond market.
  • Time. This variable is hard to gauge but it is likely safe to assume the Fed stands ready to provide support for the next year.

Implied OAS of US Corporate Bonds (%) Since July 2015

Implied OAS of US Corporate Bonds by percentage since July 2015

Source: Bloomberg LP, BMO Global Asset Management

This framework still suggests there is plenty of value in US corporate bonds despite the recent spread tightening we have seen.  After factoring in the value of the Fed put, spreads are still north of 200 bps. However, the value of the put has decreased substantially over the last few months as can be better seen here:

Implied OAS of US Corporate Bonds (%) Since March 23, 2020

Implied OAS of US Corporate Bonds by percentage since March 23 2020

Source: Bloomberg LP, BMO Global Asset Management

The primary reason that the put option has declined in value is that spreads have tightened and thus the put option has moved further out of the money. But this dynamic is also what makes the put option so important for investors. If spreads were to widen further from this point they would move closer to the strike price in a non-linear manner.  This relationship means that corporate bonds become significantly more attractive as spreads widen: (1) the spread is wider to Treasuries and thus provides better carry, and (2) the put option could become substantially more valuable as it approaches the strike. For that reason we continue to look to buy corporate bonds on weakness.

Disclosures

This is not intended to serve as a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. This presentation may contain forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such statements, as actual results could differ materially due to various risks and uncertainties. This publication is prepared for general information only. This material does not constitute investment advice and is not intended as an endorsement of any specific investment. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.

A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Basis points (bps) represent 1/100th of a percent (for example: 50 bps equals 0.50%) Basis points (bps) represent 1/100th of a percent (for example: 50 bps equals 0.50%). Past performance is not a guarantee of future results.

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