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, something that typically takes at least a year to transpire. High yield spreads initially widened dramatically providing an attractive entry point. Spreads have since begun to narrow, and continue to do so, removing some of the potential upside for taking credit risk. Still, we believe the meager yield on investment grade securities is likely to push investors further out the credit spectrum to find better yields.
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, as can be seen in the chart below.
- The financial conditions picture has become mixed. On the positive side, the Fed’s announced intention to buy below investment grade debt significantly opened the issuance window. On the other hand bank lending conditions have become much tighter and the number of ratings downgrades suggest a wave of defaults. We believe the reopening of the economy will help forestall that wave.
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.
Source: Bloomberg Barclays
Issuance: To date, high yield bond issuance has been strong surpassing levels seen in past years through May. Leveraged loan issuance remains low as defaults stack up to levels not seen since 2009. While the Fed is willing to buy high yield bonds, they have avoided leverage loans as they do not want to appear to be propping up private equity firms.
Quality: Quality deteriorated through the last cycle as demand for higher yielding debt outstripped supply allowing borrowers to set more favorable terms. Quality has since improved modestly as the terms of newer issues have become more beneficial for the lender. Additionally recent fallen angles (investment grade bonds downgraded into high yield) have increased the overall quality of the high yield market.
Coverage: Leverage and coverage ratios deteriorated over the last cycle. Through defaults these ratios should improve, though it is difficult to speculate how much at this time.
Credit spreads tend to narrow as the economy expands and widen as the economy contracts. While the magnitude of this downturn is unprecedented as can be seen in the below chart, it is likely to be one of the shortest on record. We believe we are in the early stages of a recovery as the economy reopens.
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 widened dramatically and then have pulled back to a level that is still attractive, though less so. Given how rapidly the markets are moving it is important to be current with where spreads are before making an investment decision. We believe that a more selective approach is important given a potential increase in defaults.
Source: Bloomberg Barclays
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