Trading On margin

Inflation has yet to hurt profit margins. It’s good for corporate debt.

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Inflation may be on the rise, but corporate balance sheets still look strong, says

Goldman Sachs.

And that should be good for corporate bonds, especially high yield issues.

Fears of corporate inflation do not seem to translate into lower margins, a boost in the valuation of corporate debt.

Michael Loccisano / Getty Images

The assessment marks a slight change from last month, when the bank highlighted comments from corporate management teams on price pressures – the most discussed on this topic since 2018 – as a “modest risk” for bond markets.

Executives’ comments, and a surprisingly strong inflation reading in April, raised concerns about profitability, especially for lower-rated companies. As Goldman Sachs wrote in an April 20 memo, lower-rated companies “are likely to be more vulnerable to such headwinds of profit because of their thinner financial cushions and generally weaker business models. , compared to their [higher-rated] peers. ”

The market may reflect this concern, as the performance of the high yield bond market weakened this month. the

iShares iBoxx $ High Yield Corporate Bonds

ETF (ticker: HYG) is down almost 0.3% in May, although its total return was slightly positive at 0.1%. To compare, the

20+ iShares Treasury Bonds

ETF (TLT) returned 0.7% for May, and the

iShares iBoxx $ Investment Grade Corporate Bonds

ETF (LQD) posted a return of 0.9%. Even the stock market has performed better than high yield bonds; the

S&P 500

was up about 0.4% for the month at Tuesday’s close.

The actual first quarter results for the companies are now in, and management is still very concerned about inflation, with the number of mentions of inflation and price pressures easily exceeding those of 2018.

But their actual financial results suggest those concerns may be overblown, strategist Amanda Lynam said in a May 26 note. The median profit margins of high yielding companies actually improved slightly in the first quarter of this year.

“This suggests that companies have been able to pass higher input costs on to customers and / or offset increased spending on raw materials, wages, and freight with savings elsewhere.”

While margins have also improved slightly for good quality companies, the market for higher rated bonds is trading at a low yield premium in the Treasury bill market. This market is currently only earning 2.1%, about 90 basis points more than comparable Treasuries. This gap between the returns of the two markets is the narrowest since the financial crisis, according to data from the ICE indices.

Goldman Sachs is more bullish on high yield bonds than on higher rated securities, in part because of the valuation disparity. Junk bond spreads have also tightened significantly over the past year, but have yet to hit their post-crisis low. And while high yielding companies have sold record amounts of debt this year, about two-thirds of that has gone to refinancing. The push towards refinancing has pushed the levels of rotten, good quality listed companies to the highest levels on record, she wrote.

“We do not view the pressures on margins – to the extent that they will materialize in the future – as a risk to corporate liquidity,” she wrote. “This is true even for lower quality borrowers in the HY universe, given the improvement in financial flexibility in recent quarters.”

In addition, some high-yielding sectors, such as metals, mining and energy, benefit directly from rising commodity prices which have pushed up costs for other high-yielding companies.

Goldman Sachs’ opinion is that “the recent rise in inflation will prove to be transient in the end,” she wrote, but even if inflation persists for some time, high yield bond markets should hold up better than investment grade debt.

“To the extent that additional pressure on margins materializes in the future, we would not view this as a risk to corporate liquidity – even for lower quality borrowers – due to the importance of fundraising. and the proactive pre-financing carried out during the period. the last few quarters in the primary debt market, ”Lynam wrote.

Write to Alexandra Scaggs at [email protected]

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