Credit Outlook: Investment Grade Is the Better Value Now

Summary

• Credit spreads tightened significantly over the past month as equities continued to rally and the VIX index of equity volatility traded at post-pandemic lows.
• We examine drivers of high-yield credit spreads and conclude that high yield is trading near fair value, while investment grade is still cheap following the Silicon Valley Bank collapse.
• We expect financials, especially banks, will report solid results in the upcoming Q2 earnings season, which should benefit their bonds.

Market Implications

• We would scale back more aggressive high-yield positions and overweight investment grade.
• Investors can gain exposure to investment grade via the LQD ETF and high yield through the HYG or JNK ETFs.

Investment Grade Has Room to Tighten Further

Following a nice run in June when investment-grade (IG) credit spreads tightened 12bp to 129bp and high yield (HY) gapped 40bp tighter to 399bp, spreads traded modestly wider after the July 4th holiday as equities sold off (Charts 1 and 2). A big factor was a lower VIX index of equity volatility, which mostly traded in the 13-14% range – the low point since the pandemic hit in February 2020.

At this point, we would dial back the more aggressive overweight position in HY that we favoured a month ago. With the economy and job market still robust and the Fed poised to raise rates further, we see little prospect of further spread tightening for now. The current risk is that volatility and defaults tick up. That said, we do not see significant downside risk; credit is primarily about carry at this point.

We view IG with an option-adjusted spread (OAS) of 128bp as 20-25bp cheap to fair value. The IG index is over 40% financials, which widened after the Silicon Valley Bank (SIVB) collapse and ensuing regional bank crisis.

What Is Driving Credit Spreads?

Clearly, while spreads are relatively tight, they are also well off the tights of 2021 or before the financial crisis. Is credit fairly priced given where the VIX and default rates are?

Is High-Yield OAS Still Cheap?

Here we focus on HY and do two sets of regressions, focusing on the VIX and IG spreads, respectively. These are simple models to capture the primary drivers of HY credit spreads. The data series begins in 1997. We summarize predicted HY OAS and residuals in Table 1. In the appendix, we provide regression coefficients.

In the first set, we regress the HY OAS on the VIX, the VIX and default rate, and finally add a recession dummy (top panel, Table 1). All variables are highly significant; R-squareds are in the 0.75-0.85 range.

Based on the VIX alone, the HY OAS is very near fair value. When we add the default rate and recession dummy, fair value drops to 381bp. Whether that implies the HY OAS is 30bp cheap or not depends slightly on whether you expect default rates to rise in coming months – or have concerns about a recession in coming quarters.

Using the model with all three variables (VIX, default rate, and recession dummy), the predicted value closely tracks the actual OAS for the most part (Chart 3a). There were clear dislocations where the HY OAS traded well above the predicted value. These include during the financial crisis; in 2011 after Congress nearly defaulted on Treasury debt; and in 2014-15 when oil prices sank, setting off a wave of defaults in the oil patch. These proved attractive periods to buy HY bonds.

Then there was the period during the pandemic when the HY OAS traded well below the predicted value by more than 100bp (Chart 3b). The most likely explanation is the extraordinary government support for businesses, such as the Paycheck Protection Program and moratorium on bankruptcy filings. As these programs expired during 2022, the HY OAS rose and converged with the predicted value.

Investment Grade OAS Still Reflects Banking Crisis

When we model the HY OAS as a function of the IG OAS, the predicted value of the HY OAS is far wider, at 274bp. The primary reason for this is the regional banking crisis that started when Silicon Vally Bank collapsed in early March 2023. When we add a dummy variable to account for this stress, the predicted HY OAS drops to 216bp or 7bp wider than actual. Put another way, absent the SIVB crisis we would expect the IG OAS to be trading around 105bp instead of 128bp.

Unlike equities, where financials are less than 5% of the market cap of the S&P 500, financials are over 40% of the IG corporate bond index. Many financial company bonds are trading at significantly wider spreads than before the SIVB crisis as investors fear downgrades or even defaults.

Time to Overweight Investment Grade

We think the selloff in both bank equities and particularly bank bonds is overdone. As Q2 earnings season arrives, we expect the surprise will be that most banks post good earnings, and many provide disclosures that give investors some comfort that bank failure is not imminent.

Yes, banks likely face regulatory changes that will require them to hold more capital, which will hurt return on equity performance and keep equities from fully recovering to pre-SIVB levels. But these kinds of changes will improve the credit quality of most banks.

We view the IG index as better value than HY currently. We recommend investors overweight the IG sector and market weight or underweight HY.

Investors can gain exposure to IG bonds via the LQD ETF, and HY via the HYG or JNK ETFs.

These ETFs are fixed rate so exposed to both rate risk (changes in Treasury yields) and credit risk (change in credit spreads). Investors can hedge rate risk by going short Treasury bond ETFs. We like the longer-duration Treasuries for hedging LQD, such as the IEF ETF (holds 7-10 year Treasuries), and medium-duration Treasuries for hedging HYG or JNK such as the IEF ETF (holds 3-7 year Treasuries).[1]

Appendix

The table below summarizes regression coefficients for the regressions discussed above. The dependent variable is the HY OAS. All variables are highly statistically significant, so we do not provide t-statistics or p-values.

[1] A more detailed review of Treasury ETFs is beyond our scope here. Investors can get more information at www.ETF.com or www.etfdb.com .

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.)