Corporate bonds have a higher yield than duration-equivalent Treasuries, mainly to compensate investors for default risk. This difference in yield, termed the credit spread, fluctuates over time. Credit risk refers to the risk of rising (or widening) credit spreads. In the following pages we broadly evaluate credit spread drivers to help gauge where the opportunity lies across the quality spectrum.
Conclusion: Much has changed in a short period of time. We have gone from late cycle conditions to early cycle. Credit spreads initially widened dramatically providing an attractive entry point. Credit spreads have since become narrow, removing much of the potential upside from price gains. Still, we believe the yield advantage over investment grade securities and fewer defaults should allow below investment grade securities to outperform as the economy recovers.
Financial conditions refers to how easy or difficult it is to access credit. We look at a number of indicators including monetary policy, lending surveys, financial condition indexes, and rating agency upgrades and downgrades. Tighter financial conditions historically have been accompanied by a widening in high yield spreads, and vice versa.
- The financial conditions picture continues to improve. The default rate is coming in below expectations and the ratings upgrade to downgrade ratio has moved above a rarely seen 2:1 ratio. Additionally indexes that measure financial conditions such as those compiled by Bloomberg, Goldman Sachs, and the Chicago Federal Reserve Bank have all returned to expansionary levels.
Sources: Bloomberg Barclays, Federal Reserve
Degree of Speculation
The degree of speculation built up during an expansion can significantly compound the subsequent decline. It can also cause the universe to be more vulnerable to economic weakness and/or tighter financial conditions. We evaluate three broad areas: credit issuance, quality of debt outstanding, and debt coverage. We have seen some modest improvement in all three of these factors, however, with a recovering economy, these factors become less impactful.
Source: Bloomberg Barclays
Issuance: To date, high yield bond issuance has been strong, surpassing levels seen in past years. Leveraged loan issuance has also begun to pick up with Collateralized Loan Obligation (CLO) demand.
Quality: Exposure to the lowest tranche of credit quality did not get extended as seen in past cycles and exposure to the highest tranche accounted for over half the index. Additionally recent fallen angles (investment grade bonds downgraded into high yield) have increased the overall quality of the high yield market. Similarly, defaults have taken some of the weakest credits out of the index. Conversely, for the Investment Grade index, the lowest tranche on the quality spectrum (BBB) has become the largest weight.
Coverage: Coverage ratios have been improving as a significant portion of issuance has been rolling older debt into lower rates and longer maturities. Demand is strong, especially for leverage loans to stack into CLOs, creating a trend toward looser, covenant-lite credit agreements.
Credit spreads compensate investors for the risk of default. Default risks are cyclical. Credit spreads tend to narrow as the economy expands and widen as the economy contracts. While the magnitude of the downturn was unprecedented, it was also one of the shortest on record. The chart below looks at industrial production and profits growth. The economic recovery provides a healthy backdrop for profits, and increasing profits reduce default risk.
Sources: Bloomberg, U.S. Bureau of Labor Statistics
The previous three sections covered fundamental considerations with respect to lending conditions, the economic backdrop, and the amount and quality of debt outstanding. We believe that the current valuation of debt (as measured by the credit spread) should be at least reflective of the underlying fundamentals to appropriately compensate investors for taking on additional credit risk.
- In a very short period of time high yield credit spreads shot up to over 1,000 basis points and then came back down to lows not even seen in the previous cycle. At the end of May, the high yield credit spread was just 296 basis points, putting it in the bottom 10% of historical monthly observations. We believe that a more selective approach is important given tighter spreads, though overall, we believe that very low investment grade yields and lower default risk will continue to push investors into higher yielding securities.
Source: Bloomberg Barclays
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