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: At the time of this writing widening credit spreads are being offset by tightening financial conditions related to both the Coronavirus outbreak and drop in oil prices. As such visibility is currently low. Should spreads widen further and monetary and fiscal stimulus gets put in place, we see a path towards a shift that favors high yield over investment grade. At this point we lack visibility on all three components (how far spreads widen the degree of tightening financial conditions, and how much monetary and fiscal stimulus is implemented).
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.
- Through the end of February financial conditions looked slightly loose. But in early March this began to quickly deteriorate, though to what degree was unclear at the time of writing. Should the credit spigot begin to close and stay close for an extended period, it would create a difficult backdrop for credit. We believe this to be short lived.
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. All three of these factors are suggestive of much wider spreads.
Source: Bloomberg Barclays
Issuance: High yield issuance has been strong in this economic cycle, reflective of sustained lower interest rates throughout this cycle. Both leveraged loans (aka floating rate or bank loans) and fixed-rate high yield bonds have contributed.
Quality: Issuance quality has deteriorated. We are seeing covenant erosion for fixed and floating rate high yield bonds and, according to Moody’s, quality continues to worsen as credit spreads tighten and investors search for yield. Moody’s has also noted that covenant protections have grown steadily weaker in each of the seven risk categories it evaluates.
Coverage: Leverage and coverage ratios have become weaker. The decline in coverage ratios has not been accompanied by wider spreads that were seen in past cycles.
Credit spreads tend to narrow as the economy expands and widen as the economy contracts. Most of our indicators suggest that we are in the later stages of this economic cycle. That said, we do acknowledge that this cycle has been extended due to fiscal stimulus measures and now the Fed has shifted toward a more dovish posture, which is likely to extend this cycle.
- The speed a voracity of economic slowing due to social distancing efforts such as school closings, near halt in travel, store closures, and spectator sport stoppages will likely push our economy into a recession. The depth and length of the downturn are indeterminate at this time and will depend upon when the virus peaks.
Sources: Bloomberg, U.S. Bureau of Labor Statistics
The previous three charts 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.
- Through the end of February 2020, high yield spreads widened to the historical average following the Coronavirus outbreak.
- In early March high yield spreads continued to widen the decline in oil prices (the energy sector is the largest in the high yield index) and uncertainties surrounding the extent and duration of the Coronavirus outbreak. Further widening absent a meaningful and sustained decline in fundamentals would make this asset class more attractive to long-term investors.
Source: Bloomberg Barclays
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