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: As we move further into this cycle and inflation continues to run higher than the Fed’s target, we see some near-term spread widening risk. The war in Ukraine only compounds this, though there are few direct effects and energy related debt is benefiting (~13% of the index). Looking beyond this near-term risk, we continue to see value in below investment grade credit exposure given higher absolute yields in a very low yield environment for investment grade debt, though we may need to revisit under tighter monetary conditions.
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.
- We believe financial conditions have reached a point where they can’t get any better. Whether it is defaults or ratings upgrades or absolute yields, it is likely that they begin to normalize over time. We believe financial conditions should remain at fairly attractive levels for some time to come, though the war in Ukraine could hinder issuance in the near-term.
Sources: Bloomberg, Federal Reserve
Degree of SpeculationThe 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 mixed results for these factors, with less speculation seen in the fixed high yield market and much more speculation in leveraged loans.
Issuance: High yield bond issuance has slowed. Leveraged loan issuance remains strong with Collateralized Loan Obligation (CLO) demand.
Quality: Exposure to the lowest tranche of credit quality for fixed high yield debt did not get extended as seen in past cycles and exposure to the highest tranche accounted for over half the index.
The story is just the opposite for floating rate debt, where the highest quality tranche has been shrinking. Additionally strong demand for loans has led to a significant deterioration in covenants.
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 leveraged loans to stack into CLOs, creating a trend toward looser, covenant-lite credit agreements.
Economic CycleCredit 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. 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. Our economic cycle model now suggests late cycle conditions. The circumstances surrounding this cycle are unique, making the signals hard to interpret. The pace of this cycle is much more rapid than seen in the past, raising concern that we may arrive at the end sooner than expected. That said, the signals are dispersed with many early cycle signals remaining such as healthy consumer and business balance sheets.
Sources: Bloomberg, U.S. Bureau of Labor Statistics
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.
- At the end of February, the high yield credit spread was 359 basis points above duration equivalent Treasury yields, putting it in the bottom 30% of historical monthly observations. While spreads have widened, they are not indicating any signs of stress. This is comforting given the backdrop of war, high inflation, and the Fed preparing to remove its stimulus. Many issuers have refinanced into lower coupon debt with longer maturities lessening default risks.
This commentary is for informational purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security. There is no guarantee that the information is complete or timely. Past performance is no guarantee of future results. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.
Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.
Not FDIC Insured | No Bank Guarantee | May Lose Value