Navigating Tight Spreads and Big Themes: PGIM on the Corporate Bond Outlook

Lawrence Gillum (00:00):

Hello and welcome to LPL Market Signals. I'm Lawrence Gillum. I'm Chief Fixed Income strategist at LPL Financial. And today, as we are recording this episode on the first day of June, we're diving into one of the more interesting corners of the bond market right now, the investment grade corporate bond market. Joining me is Matt Csontos from PGIM Executive Director and portfolio manager for PGIM credits, U.S. investment grade corporate bond team. His primary responsibilities include management and investment of intermediate and short corporate strategies and corporate security selection in multi-sector strategies. And I'm certainly glad to have someone with PGIM Scale and credit research depth with us today. Matt, thanks for joining us and how are you today?

Matt Csontos (00:41):

Thanks for having me, Lawrence. I appreciate the invite. We're doing well, another busy Monday on the new issue front in the investment grade corporate markets.

Lawrence Gillum (00:49):

Awesome. And we are going to unpack all the fun stuff that's going on in the investment grade corporate bond market. And here's what's making the investment grade bond market still compelling to talk about right now? So the market is caught between decently good fundamentals, right? But valuations that leave almost no margin for error spreads are sitting around 71 basis points over treasuries as of last Friday's close, which is amongst the lowest they've been since 2001, while all in yields are still above 5%, which are amongst the highest they've been since 2001. So investors are getting paid, but they're not getting compensated much for the credit risk that they're taking on. So the big questions are, are spreads justified? Are we priced for perfection? Where does PGIM value along the curve in quality spectrum? And what's the risk that, what's going on in the private credit space or even a macro shock reprices, all of this. So we will unpack all of these questions and maybe a few more over the next 20 to 25 minutes. So, big question to you, Matt. You ready to talk some markets?

Matt Csontos (01:49):

Let's do it.

Lawrence Gillum (01:50):

All right. First question. Let's keep it higher level at first. So the economy is pretty resilient as of late. So curious how PGIM is thinking about the economy broadly given the ongoing Iran conflict?

Matt Csontos (02:06):

Yeah, I think there's clearly a dual track almost for market expectation and what's going on in the economy. So there's clearly a real risk that's been kind of bubbling up in the background with the Iranian conflict. And I think that becomes most pronounced when you think about the prospect. And we've been hearing it more and more from, for example, oil executives that they're being asked about physical market shortages and we haven't really seen that yet, but that's clearly a real risk to the extent this conflict remains in place. Now, against that backdrop you have, what is a pretty supportive macroeconomic situation here, at least in the U.S.? So you're getting kind of two benefits, kind of the twin track of growth that we see, which is continued growth and consumption.

Matt Csontos (02:55):

So we see consumption growth here in the U.S. continuing to track north of 1.5%, which is a solid number. And then the real benefit from all of this AI related CapEx growth. So that by in itself is probably adding another 1% plus to growth. So we see a backdrop with growth at least 2.5% plus GDP growth here in the U.S.. And again, that's against another backdrop of this potential risk continuing to bubble up and this geopolitical kind of ping pong we're seeing in the markets is clearly not supportive for confidence go forward.

Lawrence Gillum (03:33):

Yeah, and we've got some additional headlines this morning about the on again off again, Iran conversations with the U.S. and it seems like it's just adding to a lot of volatility in the markets right now. But what's really interesting, I think, is that we've seen a pretty dramatic repricing of fed monetary policy expectations. So coming into the year markets were pricing in around two and a half cuts but now markets are pricing in an 82% chance of a hike this year. Do you think markets are right in thinking that the next move for the Fed is going to be a hike?

Matt Csontos (04:09):

Man, I wish that I had a lot of confidence there, but that has been one of the toughest calls I think more recently. And not only because of all the volatility and the macro backdrop we've been discussing, but also with just the political backdrop and the new leadership being transitioned into the Fed. So I think that the risk is actually still a little bit for lower rates over the near term. I think that Kevin Warsh has a clear mandate as he's entering this position, but boy, it's going to be tough for him to fight some of these inflationary pressures. We continue to see rise to the surface, not only from some of the geopolitical tension and risks that are out there, but also just from, again, going back to the AI related CapEx and the inflationary effect that's all having on the broader economy. So I see the market, like you mentioned pricing in no, no cuts on the horizon. I think the PGIM view would still be that we do get a few cuts over the next kind of six to 12 months. But the risk is clearly for fewer cuts as we look forward.

Lawrence Gillum (05:13):

Yeah, we're in the same camp. We do think that the Fed can potentially cut rates maybe by December, obviously. What is going on in the Mideast with oil prices in particular, that's going to be the big impediment to rate cuts this year. Also think that if you look at just the increase in treasury yields that we've seen so far after the Iran conflict began that's certainly tightened financial conditions, made consumer loans a lot more expensive. So our view is that the bar for a rate hike is a lot higher than just a Fed on hold for a little bit longer than kind of expected coming into the year.

Matt Csontos (05:52):

Yeah, absolutely.

Lawrence Gillum (05:53):

All right, let's talk about the lay of the land in corporate America. Just broadly earning season has, I think, surpassed most, if not all expectations with a fantastic earning season. So I guess the big question is kind of how are you looking at corporate America? Is corporate America still in pretty good shape?

Matt Csontos (06:14):

Yeah absolutely. And I don't think it can be really overstated 25% plus earnings growth this earning season with the expectation heading into that probably like half of that growth rate. So it's just been incredible and it's been fairly broad based as well, Lawrence. So we've seen exceptional results, for example, out of the banking space, we've seen very strong results as you can imagine around some of the tech names, although obviously there is a little bit of a bifurcation with those that are under kind of the lens of the impact from AI, not really seeing that yet in the results, but clearly weighing on some of the market fundamentals there. But I would just say this is some of the strongest growth we've seen kind of in the entire post COVID era.

Matt Csontos (07:01):

And again, with it being fairly broad based, it does tell you a lot about the health in corporate America and the resiliency. You know, we look back to like April of last year when all of the concerns around tariffs were kind of at the forefront. If anything, I would say the one thing that has fundamentally kind of changed along that path has just been the impact has just been slower and maybe more drawn out than what we expected. So rather than that kind of spike in inflation that you might have seen initially from the tariff kind of shock, that definitely has been more extended. And a lot of that can be attributed to just management team expertise managing around supply chains, managing around their purchase orders and how they've been able to pass through some of those costs maybe more slowly than expected to the consumer base.

Matt Csontos (07:49):

And then the consumer base has been able to absorb that. And that leads into bigger economic questions around how much are consumers relying on the wealth effect maybe to support continued consumption growth versus what we're seeing now more recently, which is maybe real savings actually dipping into negative territory as inflation has spiked over the last month or two. But that all being said clearly some healthy results across the corporate earnings landscape. And I would say, if anything, we went from a period maybe with the first quarter earnings releases in April listening to management teams, and there was a little bit more concern around the time, as you can imagine, around just the geopolitical uncertainty in the businesses to a little bit more confidence now go forward. And I think they are seeing some of the benefit as well from some of the investments they're making on the AI side also start to come through productivity. Obviously still very early days there and a lot remains to be seen. But so far the landscape, if I could sum it up in one word, is just healthy.

Lawrence Gillum (08:53):

That's great context there, Matt. So I am curious though, are we at peak quality within the corporate bond market? We've seen more upgrades and downgrades over the last few years. Is this as good as it gets or do you think this trend can continue?

Matt Csontos (09:09):

Yeah, we have this debate a lot internally and I think it's gone under the radar a little bit for some of those who might not be the more focused market watchers for investment grade corporates, but there has been a meaningful shift right in the composition of the index. So there's been a shift from more triple Bs to more single A and higher ratings. So the triple B share of the index, which used to be a little over half, has now dipped to something like 46-47% that's been meaningful. And then just away from that, with the move in rates kind of away from quality, but if you just think about the construct of the investment grade corporate markets with the move higher in rates the duration of the index has shortened up quite a bit as well, especially from the days of kind of that zero interest rate environment in 2021 and early 2022.

Matt Csontos (10:01):

So the spread sensitivity or spread duration, as we like to call it in the index, has actually shortened up quite a bit as well. So not only do we have fewer triple Bs, we have a shorter duration kind of overall aspect of the index, and then the share of the index that is a low triple B is actually at, or setting new kind of record lows. So sub 10% in that category that is kind of the most at risk to falling to below investment grade or to high yield. So there has been a meaningful shift, and I think that does go overlooked at certain points. But whether or not we're at kind of peak overall quality in the index is a good question. We have had a period for the last several years where M&A has been relatively benign.

Matt Csontos (10:46):

M&A tends to actually be one of the most harmful aspects to corporate credit quality, especially at the higher end of the investment grade credit spectrum. So I don't see an environment where that M&A activity remains as benign go forward. And if anything we've heard from M&A bankers and syndicate teams that the activity there kind of behind the scenes is only accelerating. So I see that as maybe a risk to the index credit quality going forward. And then some of the index improvement or a good share of it has come from the banking industry, which obviously post great financial crisis took a lot of downgrades. But the industry with all of the regulation has actually slowly crept higher in the investment grade credit rating spectrum. So that's something that maybe is starting to come to an end, I would say, away from the multi notch upgrades that we've seen over the last several years. So remains to be seen, but I think there are plenty of arguments to suggest that maybe we are approaching peak credit quality.

Lawrence Gillum (11:51):

All right. Appreciate all of that. So we do have to tackle the big question ahead of us, and that's the valuations. We talked about spreads that are relatively tight versus history yields still pretty attractive versus history, I guess when you're building portfolios, how do you think of valuations and how are you balancing low spreads, high yields?

Matt Csontos (12:12):

Yeah credit is tough because there is, at some point, a theoretical floor for credit spreads. Right now, as you mentioned, the index is in the low seventies. That is kind of like multi-decade tights on the investment grade credit index. And a lot of the overall tightness of the index, if you kind of want to break out the index, it's about a third, five year and in about a third five year to 10 year maturities, and then about a third 10 year plus maturities. And all of it is on the relatively tight side on a historical basis, but really on the most compressed side is going to be on the 10 plus year maturity bucket for lack of a better term. And so what you've seen effectively is spread curves have flattened pretty materially, and a lot of that can be ascribed in my view to the all in yield picture, right?

Matt Csontos (13:08):

So 5% yields on the long treasury and then you probably get about 90 basis points on average in long corporates versus something like 60 to 70, more so in shorter and intermediate corporates. So those spread curves, which historically have been much steeper, have flattened out a lot. That demand for all in yields is coming from a lot of places. So some of it is coming internally, meaning domestically from retail and institutional investors, but a lot of that demand for yield is coming from overseas into our market. And I don't really see that slowing down insofar as long end yields stay where they are. But certainly it leaves very, very little margin for error. And one of the ways I like to describe it is if you have a spread of 90 basis points on a long end bond, that bond will have a duration of let's say 15 to 20 years.

Matt Csontos (14:02):

It only takes a few basis points of spread widening for you to completely eliminate on a cost basis your carrier that you would've received annually for that bond. So you would totally wipe that out with just a few basis points, again, of spread widening. That to me is not a great risk reward, especially given where spreads stand today. Now the front end of the market is still compressed, but on historical basis not as compressed as it has been. And you do have a little bit more in terms of breakeven spread widening the terminology I like to use before you would see kind of negative excess returns. So I do see a little bit more value in the front end of the market. We as a firm are trying to position for more what we like to call carry and roll in the front end of the market.

Matt Csontos (14:50):

So taking advantage of steeper spread curves and positioning the portfolios to out carry the benchmarks rather than taking more swings to capture spread tightening from a longer spread duration perspective. I think you don't give up a lot right now to be in a more defensive posture, and the fact that front end rates are as elevated as they are and for the foreseeable future kind of feel like they'll stay relatively elevated you can park a lot of liquidity, right? So you could park in cash and treasuries, you're not giving up a lot of overall yield by doing that, and you're able to take advantage of maybe some mini spread vol spike situations to add a little bit more risk here and there in the portfolios to be a little bit more nimble. For example, what we did in the portfolios in March as spreads hit their wides of the year, which would've been the low nineties take a little bit more risk on. So that's something we're trying to do. We're trying to be really disciplined not to get sucked into this kind of low volatility, low spread environment. But it can be challenging at times as spreads continue to march tighter.

Lawrence Gillum (15:59):

Yeah, we're in the same camp, we've been favoring the short to intermediate parts of the curve — the corporate curve and the treasury curve just given how flat those markets are. So that's kind of the advice that we've been providing to our advisors. So it's great to hear you say something similar. I do have to ask you a quick question though, as it relates to the quality of the bond market. This is a debate that we have internally. There's some folks on our team that say that the corporate bond market, the investment grade corporate bond market is the new risk free market with spreads as tight as they are. I think there's an argument that spreads are tight partly because of what's going on in the treasury market, the return of the term premia et cetera. Are you in the camp that the corporate bond market is a safer, I don't like the word safer, but is it the new risk-free market

Matt Csontos (16:53):

<Laugh> the return free risk term? I like that. I have had this argument internally and with several of our counterparts and on the sell side or whether or not the term premium is having an effect overall. And whether that's measured by swap spreads or other kind of academic exercises to evaluate what exactly that term premium is. I do think, Lawrence, that there is maybe a little bit of that going on. It's really hard to measure and put your finger on an exact figure there. But I do feel like that is having some impact overall, right? So the fact that you do still have, for example, pretty steep treasury curves, like, and I look at five tens, twenties treasury curves at north of 50 basis points. It does feel like there's an attractive point for example, at the 20 year point to kind of capture some roll down the curve. But I do think that is having a little bit of an impact. I would just say again, depending on how that term premium is being measured we're nowhere near the highs historically on that basis. So kind of taking a swing to play on that term premium it might be a little bit challenging 'cause that theoretically could continue to grow.

Lawrence Gillum (18:06):

And then how about those rare companies? You don't have to name names, but there are some companies out there with negative spreads to treasuries. Are these the antidote for the treasury market and the fiscal issues that are taking place within the treasury market?

Matt Csontos (18:22):

I'd be happy to know. We probably don't own any of those names. Hopefully we sold them as they were approaching negative spreads, but there are only a handful I would say of those types of names. And they are, at least in many cases, if we're talking about the same ones, would be AAA rated. Versus obviously the U.S. government has taken a downgrade, so higher quality from a rating agency perspective. I don't know if you could follow through with the argument that ultimately that would come to fruition, but there's certainly supply pressure that exists in the treasury market that doesn't exist for some of these very high quality corporate issuers. But I would just be <laugh>, I would not be out there personally buying those names through treasuries.

Lawrence Gillum (19:07):

Yeah, that's the side I come in on as well. It seems like there's been a lot of demand for these higher yields, which I think are keeping spreads well contained. You mentioned supply, and this wouldn't be a podcast in 2026 if we don't talk about AI and tech and the issuance there, a lot of supply, but demand for that paper has been relatively well supported. We have seen some spread widening in the tech space relative to the index, but if you look at just the amount of demand for some of these AI tech issues, it's been pretty supportive. I guess what are your thoughts on the market's ability to continue to absorb this new issuance?

Matt Csontos (19:47):

Yeah, so I think we just crossed over a trillion of gross supply in the investment grade credit market this year, probably on pace for 2 trillion, which would be basically a record. Since 2020 for gross supply, that 2 trillion probably equates to something like 500 to 600 billion of net supply that needs to be purchased by somebody. And the sources of demand or incremental demand that we see are coming from a combination, it seems like, of retail investors and then overseas demand that I alluded to earlier. So we are still seeing the market absorbing the supply pretty readily. You know, new issue concessions have been very modest, if positive at all, and then the secondary, but the secondary buying of a lot of these new issues has been relatively benign as well.

Matt Csontos (20:45):

So it does feel like the market is being, or new issues or at least are being brought kind of to perfection in many cases, getting squeezed for lack of a better term basically as tight as they can go. And yeah, I do think the hyperscaler issuance is really the main story when it comes to supply. So 2 trillion of gross issuance for the broad market, and probably the estimates are relatively wide, but probably north of 200 billion of issuance from the AI hyperscalers. So north of 10% of issuance, and that is a significant number, especially in the context of where they've issued or how much they've issued historically. What we see is that the names or sectors that are most impacted when it comes just from technical overhangs, are those where you see big shifts in their issuance patterns, right?

Matt Csontos (21:38):

So the money center banks are collectively some of the largest issuers in our market, but they only typically issue around 150 billion or so per year, and it's on a pretty regular cadence. So the expectations are there for that. There's also a lot of maturities and coupons that come from those issuers. So the net supply numbers are relatively modest if positive at all. Whereas for these hyperscalers, almost all of this is kind of new issuance, right? And a lot of it is long dated. So when you look at the proportion of their issuance that is coming in the long end of the market it's pretty significant <laugh> and outside of these hyperscaler deals, there's actually been a lot less supply in the backend of the market. You know, we talked about spread curves being compressed from a demand perspective, but partly that's also just the supply hasn't been there for the same reason investors are interested in buying yields in the backend of the market.

Matt Csontos (22:33):

Corporate treasurers are less interested in capturing these higher, relatively elevated 30 year yields all in with those coupons and kind of keeping those for 30 years, right? So they're, they've been shunning the long end of the market, but sectors like the hyperscalers, which don't really have a choice and kind of need to issue wherever they kind of can to get the demand, they are heavy issuers for sure in the back end of the market. So as you noted earlier, we have seen a little bit of a decompression in tech spreads versus the rest of the market. A lot of that has been associated with this elevated supply. But then I'll just make the point as well, not all of this tech or hyperscaler related supply even works its way into the traditional investment grade corporate benchmarks, because a lot of it is being done in a pseudo-private manner or under a Rule 144A, which is also kind of a semi-private form of issuance.

Matt Csontos (23:32):

So it doesn't actually make its way into the corporate benchmarks, but a lot of corporate investors such as ourselves still look and often invest in that new issue. So it does kind of absorb some of the demand as well, even if, again, it's not contributing to overall index supply. But we see it continuing, although a lot of that hyperscaler supply does seem to have occurred in the first kind of five months of the year. No signs, in my opinion, of that slowing down just given the fact that CapEx expectations for that space just continue to rise north of 700 billion now for the year. And still a ways off from those issuers becoming cashflow break even or seeing real returns on this investment. So expect that to continue to grow, expect that to continue to be an overhang on corporate supply for our market go forward. So we'll see how it all kind of shapes up, but at least it feels like maybe we have a slight reprieve near term with some of that supply.

Lawrence Gillum (24:33):

Awesome color there, Matt. To your point about these issuers diversifying their bond issuance, we've seen some of this issuance go into the non-U.S. developed markets as well and including, what was it a hundred year bond from? Was it Alphabet that recently had a hundred year bond? Were you a buyer of that?

Matt Csontos (24:53):

So that would've been handled by our team based in London, who looks at the non-U.S. dollar denominated debt there. So they have been certainly active just as we have in the hyperscalers. But it does <laugh>, it does remind me of for example, the Austria a hundred year bond going back a few years ago. Arguments could be made even though you were down in dollar price, certainly after you came off a zero interest rate environment that the convexity, you got paid for that convexity ultimately, which is a fun academic kind of exercise. But yeah we'll see more creative structures. You mentioned a hundred years. We're seeing early chatter around GPU financing, potentially making its way to investment grade markets, which would be at least new for us.

Matt Csontos (25:41):

And then there's been really very focused single asset data center issues that have come to the market. And these carry some of the biggest individual qip sizes that we see. And again, these are not even, some of these are not even in the indexes, so we'll see go forward. But yeah, it seems to me like you're going to get more and more creative structures, more and more kind of how do you finance anything? So to me at least that means you've gotta be a little bit cautious right on your overall exposure to these types of names and be really nimble and really be decisive about which ones you ultimately play.

Lawrence Gillum (26:20):

All right, good stuff there, Matt. Let's switch gears a little bit and talk private credit. So far a lot of negative headlines out there, but I think the spillover into more of the public markets has been relatively contained, I guess thoughts on the private credit market broadly and any sort of spillover concerns that you guys are having or seeing?

Matt Csontos (26:40):

Yeah, so private credit, at least as far as the investment grade market, it's just not as meaningful. But there are some individual sectors and industries where you do have a little bit of that kind of making its way into broader concerns around credit quality. So first and foremost might be in the life insurers, which tend to carry fairly sizable investment grade or even sometimes sub investment grade rated private credit exposures. They tend to have a much longer history and a lot of that tends to be more in the kind of direct lending side of the business, which it feels, at least to me sitting on the outside a little bit as a little bit more protective towards lenders. But certainly the most acute industry for investment grade would be in the BDC sectors or the business development company.

Matt Csontos (27:33):

So that's a sector that's grown a little bit in our market over the last several years. It's still relatively small. If you look at the broad corporate index, only a few percent in terms of market value, but spreads there have really underperformed over the last kind of 12 months or so. So spreads are much wider than the index. We talked about a low seventies level on the index. These BDCs tend to issue pretty short duration, so like five year and in but those spreads are, call it three times the spread of the broad corporate index. So clearly some concerns priced in there and they obviously have almost entirely kind of private credit underlying loans that are being made out of those BDCs. And then we would be lending to those BDCs. That is a concern.

Matt Csontos (28:22):

You know, we at PGIM have generally been on the investment grade credit side, underweight those BDCs and then kind of took a fresh look towards the end of last year and early this year, given the spread under performance whether or not this was a sector that still made sense to retain that still-sizable underweight. And we did ultimately make a few investments in the space really focusing on BDC underwriters that have a lot of scale and strong long-term track records, and then obviously very focused on the underlying books, right? So the software exposure, the PIK loans, the non-performing loans in those books, and then ultimately making a decision from there. But there are still a lot of concerns, especially in the perpetual private, non-traded BDCs around redemptions, right? So as long as those assets, at least as investors are viewing it, maybe are marked too highly, you probably continue to see outflows. Fortunately for them, they do have the gating feature at 5% a quarter, so you can kind of put a little bit of a break there on some of the pressure from the outflows, but probably going to actually see more issuance to support those outflows over the next few quarters.

Lawrence Gillum (29:34):

That's interesting. We've talked about private credit and that gating feature — a feature and not a bug of the investment landscape. So that has helped kind of keep some of these issues from spilling over into broader markets. Now Matt, we are at time I do want to have you give us a sense of what the rest of the year looks like within the corporate bond market for investors. No guarantees of course, but what are you thinking for the rest of the year?

Matt Csontos (30:05):

Yeah, I'm looking at my crystal ball right now and it's telling me, right <laugh>, it's telling me I think just rolling spikes of volatility, but just continued demand in our market that probably keeps spreads, at least in our view from a relative value basis. Too tight. So you want to be a little bit more defensive than you probably have been historically. You want to carry, as I mentioned earlier, a little bit more liquidity, and play more for that carry and roll, and then take your shot when it's warranted. For example, we got pretty involved in that hyperscaler issuance that came at really large concessions, even the software names that came at really large concessions but then kind of move on. So make sure you're recycling the risk appropriately and just be more nimble around the overall risk in the portfolios. So for us at least we're running risk on the lower end of where we have over the last several years and want to take advantage as I mentioned we did in March, of some of that spread widening.

Lawrence Gillum (31:04):

Awesome stuff. So with that, Matt, I think we can wrap. I want to thank you very much for being here. This was fantastic. I learned a lot, and I'm sure our listeners will learn a lot as well. So thank you for spending the time with us this morning. And thanks to everyone for listening. We will be back next week with LPL Market Signals. Thanks again for listening. Take care everybody.

Matt Csontos (31:27):

Thanks Lawrence.