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. We broadly evaluate credit spread drivers to help gauge where the opportunity lies across the quality spectrum.
Conclusion: Financial conditions moved swiftly toward being tight as the Fed signaled a more aggressive approach to monetary tightening and suggested it was willing to sacrifice economic growth to tame inflation. While high yield credit spreads widened in response, they currently do not reflect much weaker economic conditions. The changed backdrop of a more aggressive Fed led us to shift toward higher quality exposure.
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.
- Financial conditions have moved swiftly as the Fed signaled a need to be more aggressive in removing its accommodative stance. High yield and leveraged loan issuance has slowed significantly and we have seen a number of our indicators move toward a less friendly lending environment.
Sources: Bloomberg, 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 mixed results for these factors, with less speculation seen in the fixed high yield market and more speculation in leveraged loans.
Issuance: Both high yield bond and leverage loan issuance have diminished following a rise in rates which raised concerns about economic growth.
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 has fallen off for leveraged loans and prices have moved lower.
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 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 some early cycle signals remaining such as healthy consumer and business balance sheets.
Sources: Bloomberg, U.S. Bureau of Labor Statistics
Content in the previous 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.
- At the end of May, the high yield credit spread was 402 basis points above duration equivalent Treasury yields, putting it in the 45th percentile of historical monthly observations. While spreads have widened, they are still not indicating signs of stress. We do acknowledge that many issuers have refinanced into lower coupon debt with longer maturities lessening default risks, but don’t believe current spreads fully reflect the rapidly changing economic landscape.
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.
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