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Commentary by Pasi Hyttinen, portfolio manager, fixed income indexing, and Samuel Lopez Briceno, senior credit analyst.

American baseball legend Yogi Berra famously said: “In theory, there is no difference between theory and practice. In practice, there is.” Similarly, when it comes to corporate bonds, some might say that in theory, technicals do not matter to long-term investors, but in practice they do. Or do they?

You often hear investors talking bond market dynamics in terms of technicals as opposed to fundamentals. Fundamentals are factors that you would want to consider as a long-term investor, such as profitability, growth, leverage and the economic backdrop. Fundamentals matter regardless of the market sentiment, even in private transactions. Technicals, on the other hand, relate to supply and demand and investor sentiment in financial markets, which in practice can also impact security prices. Technical factors have the potential to push prices higher or lower than would otherwise be justified by the underlying fundamentals alone. They include seasonality effects, supply events and regulatory considerations. And usually technicals have only a temporary impact on market prices.

Tension between fundamentals and technicals

Financial markets are in the middle of a significant shift. It appears that the fundamental factors that investors traditionally analysed are playing a less pronounced role. Meanwhile, the most important technical factor—quantitative easing (QE)—has not only become much larger in size, but also a more permanent feature of the market landscape. Understanding this tension between fundamentals and technicals is of the utmost importance for active portfolio management as various risk premiums (such as duration, credit spreads and equity risk premia) have been suppressed, not to mention less predictable. As a result, investors are paying more attention to technicals than they did in the past.

Having said that, we strongly believe that fundamentals still play a very important role. For one, no amount of QE can ensure that all companies are run well and remain competitive. In general, the corporate credit sector offers ample opportunities for bottom-up analysis and issuer selection; in some cases, the indiscriminate QE-related flows can even create more such opportunities. Unsurprisingly, in the context of the ongoing Covid-19 crisis, many corporates’ fundamental metrics have deteriorated sharply. As seen clearly in Figure 1 –– revenues, earnings per share (EPS) and earnings before interest, tax, depreciation and amortisation (EBITDA) year-on-year growth ratios all turned strongly negative during the Q2-2020 results season. The graph also highlights the significant amount of corporate debt purchased by central banks in the euro area, the UK and the US, as well as the tightening of corporate credit spreads.

It is probably not a coincidence that central-bank debt purchases have boosted demand and led to tighter credit spreads, and hence higher corporate debt prices. However, at the same time, fundamentals are deteriorating sharply.

Figure 1 - Fundamental indicators, corporate debt QE, and credit spreads

Figure 1 - Fundamental indicators, corporate debt QE, and credit spreads

Source: Vanguard, Bloomberg data. 

Note: Sales, EBITDA and EPS growth data, expressed in last 12m trailing y/y changes, belong to companies that are part of the SXXP Europe 600 index. Data are from December 31, 2015 to September 30, 2020.

Past performance is not a reliable indicator of future results.

If we take a longer-term perspective, we can also observe in Figure 2 how the negative revenue and earnings trends for corporates, together with increasing indebtedness levels in the current low funding-cost environment, have had a direct and pernicious consequence on companies’ balance sheets, mainly through leverage. Net leverage is now at its highest level for around two decades in the European investment-grade credit universe, and significantly worse than during the global financial crisis.

Figure 2 - European investment-grade net leverage

Figure 2 - European investment-grade net leverage

Source: J.P. Morgan, S&P Capital IQ.

Note: Data are from January 1, 2002 to June 30, 2020.

While the fundamental metrics for corporates are generally in poor shape, this is currently overshadowed by the remarkable technical support provided by QE programmes globally. Indeed, some investors argue that fundamentals have become irrelevant. However, we beg to differ.

Fundamentals remain important

There has been a significant dispersion in market performance across different issuers and sectors. As Figure 3 shows, (we use dispersion in equity performance as a proxy for credit spreads across sectors) there are clearly winners and losers from the current situation, regardless of the overall direction of the market. Despite the impact of QE, fundamental analysis is critical in this technically driven market, as selecting the right names and sectors can allow investors to generate performance beyond that of the index.

Figure 3 - Dispersion in equity performance across sectors

Figure 3 - Dispersion in equity performance across sectors

Source: Vanguard, Bloomberg data.

Note: Performance is measured by the MSCII All Country World Index (USD). Data are from January 1, 2020, through September 23, 2020.

Past performance is not a reliable indicator of future results.

So, what does this all mean for investors? As corporate spreads tighten, driven by QE and related flows, there are significant opportunities for active investors to add value by being overweight the right names and underweight the weaker credits in the context of the current crisis. By focusing on bottom-up fundamental analysis, active credit investors can selectively invest in the issuers and debt structures that are most likely to withstand the crisis.

So while some investors are asking whether the current environment is a chance to ignore fundamentals, at Vanguard, we don’t believe that ignoring fundamentals is the right response. Our investment process is anchored on both a thorough bottom-up fundamental assessment and a risk-adjusted relative-value approach. This is self-evident in a weak market environment, and—even in a positive market driven by technical factors—corporate fundamentals still matter.

Investors in both our active and index funds benefit from our credit research team’s risk-adjusted and fundamentally driven approach. That’s because it’s not only directly implemented in the management of our active credit funds but also, through our sampling-driven process, in our bond index funds.

Important risk information:

The value of investments, and the income from them, may fall or rise and investors may get back less than they invested.

Past performance is not a reliable indicator of future results.

Funds investing in fixed interest securities carry the risk of default on repayment and erosion of the capital value of your investment and the level of income may fluctuate. Movements in interest rates are likely to affect the capital value of fixed interest securities. Corporate bonds may provide higher yields but as such may carry greater credit risk increasing the risk of default on repayment and erosion of the capital value of your investment. The level of income may fluctuate and movements in interest rates are likely to affect the capital value of bonds.

Important information:

For professional investors only (as defined under the MiFID II Directive) investing for their own account (including management companies (fund of funds) and professional clients investing on behalf of their discretionary clients). Not to be distributed to the public. In Switzerland, for professional investors only.

The material contained in this article is not to be regarded as an offer to buy or sell or the solicitation of any offer to buy or sell securities in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.  The information in this article does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this article when making any investment decisions.

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© 2020 Vanguard Asset Management, Limited. All rights reserved.

© 2020 Vanguard Investments Switzerland GmbH. All rights reserved.