Credit Outlook: Spread Tightening Has Run Its Course

Summary

• Credit spreads have trended tighter in recent weeks, despite some high-profile defaults and downgrades of regional banks by Moody’s. Bottomline, these events have been in market prices for months.
• One indicator still flashing yellow is quality spreads, or difference between spreads for rating cohorts. These widened in September 2022, when recession concerns peaked, and are still at levels implying concern among credit investors about recession risk.
• In the investment grade sector, industrials and utilities have fully recovered from the Silicon Valley Bank (SVB) selloff, but financials are still trading some 10bp wider than pre-crisis levels. We expect further recovery to be gradual.

Market Implications

• Credit spreads are near cyclical tights. We expect a combination of defaults and downgrades to limit further upside for high yield but do not expect spreads to blow out.
• We continue to favour investment grade over high yield but acknowledge financials may cause some spread volatility.
• Investors can hold investment grade bonds via the LQD ETF and high yield via the HYG and JNK ETFs.

Recent News Is a Non-Event for Credit

Corporate bonds have had a good month, with major investment grade and high yield indices trending tighter until the past week when risk assets hit a speed bump. There was no one catalyst – just a mixed bag of things to give investors pause. These included slow growth in China, concerns about Federal Reserve (Fed) policy and inflation, mixed outlooks from companies during earnings season, and Moody’s downgrading the US and a bevy of US regional banks.

Credit spreads widened slightly, primarily because of an uptick in equity volatility (Charts 1 and 2). We would even say recent negative news has been a non-event. We refer to the recent bankruptcy filings of Yellow Corp. (YELL) and Bed Bath and Beyond (BBY). Both situations have been slow-moving trainwrecks for months. Their bankruptcy filings offered no new information.

Moody’s Downgrade of Banks – Too Little Too Late

And then there was Moody’s downgrade of a bevy of regional banks and placing others on watch for downgrade. Markets initially seemed to react nervously but soon shook it off.

Small wonder. There was no new information in the report. Anyone who cared about banks spent weeks after the SVB collapse studying the financials and every scrap of available data about publicly traded banks. Everything in the Moody’s report was in the market and bank prices months before it was published.

Ratings agencies are privy to a lot of information about the companies they rate. There is no reason why that report could not have been published within a week or so after the SVB debacle. It would have been useful information then.

All Moody’s did with this report was to broadcast to the world their ongoing ineptitude. Clearly they learned nothing from the rating disasters of synthetic CDOs before the GFC.

Is it any surprise that SVB carried an A3 rating from Moody’s the day before the collapse?

Quality Spreads Show Recession Concerns Persist

Broad credit spreads show little sign of stress, but what about secondary indicators? One useful measure is the spread between rating sectors, or quality spreads (Charts 3a and 3b).

One point that stands out is how wide quality spreads are now relative to 2021. They are trending in but very gradually.

Quality spreads gapped out in September 2022, when inflation came in higher-than-expected, and the Fed boosted Fed funds 75bp to 3-3.25%. The S&P 500 sold off about 10% as recession fears took hold. Equity markets of course shook off recession concerns long ago, and now even bears are throwing in the towel.

But quality spreads suggest corporate bond investors are still cautious. Especially notable is the still wide gap between CCC and BB spreads. The CCC sector is small – less than 10% of the high yield market – and quirky so we are not reading too much into this now, but it is something to watch.

More generally, we are watching to see if quality spreads across the board keep tightening (indicating receding recession risk) or seem to hit a floor. In the latter case, it may be just a matter of time before recession fears start to reemerge in other markets.

Financials Are Still Recovering

After the SVB crisis, investment grade spreads gapped out some 40bp. This is modest by historical standards (Chart 4). During normal times financials tend to trade tighter than other sectors, reflecting their higher credit quality and shorter maturity.

But during times of stress financials usually widen more than industrials and utilities. During the GFC, the first near US default in 2011, and in March 2020, financials traded considerably wider than Industrials and utilities. One notable exception was in 2015, when the energy sector came under particular strain when oil prices dropped from over $100/bbl to less than $50/bbl.

When SVB failed, financials blew out by 60bp (Chart 5). But the widening was systemic too – industrials widened 38bp and utilities widened 25bp on concerns about knock-on impacts of bank lending.

Spreads have grinded tighter since, but financials have clearly been the driver of the overall IG spread. At this point the IG spread has fully recovered, and industrials are about 8bp tighter than pre-SVB levels.

Financials remain 10bp wider than early March levels. Given that financials are about 30% of the IG index, as financials fully recover the IG spread will tighten another 3-4bp (assuming industrials and utilities are unchanged).

IG Over HY

We continue to favour investment grade over high yield currently. With the HY index trading near 385bp, we see little upside from here. The default rate and downgrades will creep up in coming months and quarters as more companies must refinance debt at much higher rates. We do not expect these developments to cause a blowout, but they will keep widening pressure on HY.

The big vulnerability for investment grade remains financials, primarily in the form of headline risk. Bad news about commercial real estate or unexpected bank closures or mergers will likely push spreads wider. The offset is that the Fed and regulators are sensitive to these issues and will support the banking system in the event of any major negative news. In addition, the prospect of higher capital requirements may be a negative for bank equities – but additional capital buffers will be credit positive.

Credit investors may have to live with some spread volatility, but we expect spread premiums are sufficient to offset this risk.

Investors interested in corporate credit can hold market-level ETFs (LQD for investment grade; HYG or JNK for high yield). We have discussed the major sectors of the investment grade index, but unfortunately ETFs for subsectors are not available – investors interested in subsectors need to buy a diversified portfolio of individual company bonds.

Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)