Over the last decade, corporate bond and equity markets have largely moved in sync, but in 2022 the relationship has begun to collapse. The historically close relationship between these asset classes makes sense. Corporate credit yields are made up of the risk-free rate (used for the equity discount rate) and credit spreads (used as an assessment of risk).
Now, however, global corporate bond yields are near decade highs, as credit investors appear far more worried about central bank policy and stagflation than equity investors.
While the move has been violent, credit spreads have only expanded to 10-year average levels off a very low starting point. At the same time, yield curves have flattened rapidly, and in some cases have inverted, which can often signal changes in medium-term growth and the potential for a recession. Equity investors should be paying close attention to these credit market dynamics.
At Altrinsic, we pay close attention to multiple elements of a company’s capital structure, including leverage and covenants, but we also watch for messages being sent from our credit peers. Who is “right” this time around remains to be seen, but it is hard to argue that the multi-decade tailwind of falling rates and low inflation will be repeated. This tailwind disproportionately benefited the two ends of the quality spectrum, namely leveraged deep cyclical businesses on one end and “quality growth” stocks on the other end. We continue to find compelling investments in between these two extremes among companies that have opportunities to improve returns on invested capital through cost efficiency, improving business models, and better capital allocation.
