The corporate bond market remains an attractive place to invest despite the significant tightening that has occurred in corporate spreads since March. Furthermore, we think its appeal transcends economic expectations. While there is still room for additional compression should the economy continue to improve, the corporate market currently is priced to perform better than other risky asset classes if the recovery fails to take hold.

While economic data releases of late have been somewhat inconsistent, leading indicators in aggregate have pointed to a return to positive GDP growth and an improvement in corporate profitability. For example, as shown in Figures 1 and 2, there has historically been a strong relationship between changes in the ISM Manufacturing New Orders Index and quarter-over-quarter growth in real GDP and improvements in corporate profitability. The rebound in new orders earlier this year correctly foreshadowed the return to positive real GDP growth in the third quarter of 2009. While final third quarter results for our corporate profitability measure are still pending, we expect this data to indicate continued improvement as well.

Figure 1: GDP Growth Likely to Follow the Rebound in New Orders
 

Figure 2: Corporate Profits Should Continue to Recover
 

Credit markets tend to be anticipatory and have factored in pending improvements in corporate profitability and the economy in general. Steady inflows into the asset class have also provided strong technical support to the credit markets. Low yields on money market funds have driven investors into the front end of the corporate market in an effort to enhance yield. Insurance companies have begun to reallocate or increase their allocations to corporate credit again and — given the poor performance of equities during the past decade — pension funds have also started to increase their allocations to the fixed income markets. These inflows, illustrated in Figures 3 and 4, have been among the drivers of corporate spread tightening.

Figure 3: Fixed Income Funds Attracting Investors
 

Figure 4: Pension Funds Increasing Their Allocations to Bonds
 

A natural question is whether investors have gotten ahead of themselves in pricing the anticipated economic recovery into corporate spreads. To address this, we constructed a linear regression of the option-adjusted spread (OAS) for the investment grade and high yield markets versus a variety of economic variables, as shown in Graphs 5 and 6. Regression analysis cannot easily capture the impact of significant qualitative factors that affect the markets — such as the government’s backstop of systemically important financial institutions — but it can be a useful tool within a broader analytical framework. For example, it seems unlikely that the government will allow another large financial institution to fail, which might justify tighter financial spreads (and overall credit spreads) than might otherwise be suggested by the economic data. When taken into account with other factors, we believe that the regression estimates are generally supportive of our view that credit spreads have not tightened disproportionately relative to the changes in the economic data.

Figure 5: Our Regression Estimates Are in Line with Both Credit OAS…
 

Figure 6: …And High Yield OAS
 

Even so, investors still may wonder whether it’s reasonable to expect additional spread tightening in the corporate market after the significant compression experienced over the past nine months. We believe the answer is yes. While debate continues as to whether the economic recovery is sustainable, spreads remain priced for a mild recession despite consensus economic forecasts that call for real GDP growth of about 2.5% in 2009 and about 3.0% in 2010. Consequently, we believe that investors are being adequately compensated for the risk of a “double dip” in the economy and are being more than adequately compensated for a return to positive real GDP growth, even if that growth proves to be a bit lackluster relative to prior recoveries. As can be seen in Figure 7, investment grade credit and high yield spreads remain near the peak levels of the last recession. 

Figure 7: Spreads Still Wide Relative to Previous Economic Cycles

For those who are bullish on the economy, credit markets still offer value and room for additional spread compression. For those who are less certain that the recovery is sustainable, comfort can be had from the knowledge that spreads are still priced for a mild recession. In the event that the recovery falters, Treasuries may be the best performing asset class, but investment grade credit will still likely perform well relative to other risky asset classes. If the economy continues to recover, we expect both the investment grade credit and high yield markets to perform well relative to Treasuries.