Credit Outlook: We Favour High Yield

Summary

• Investment grade and high yield corporate bond spreads are trading in a narrow range, in line with equity volatility.
• We see little risk of a systemic widening until the default rate starts rising.
• As long as the risk of recession remains low, the default rate will remain near cyclical lows, and there is little risk of systemic widening.

Market Implications

• The high yield exchange traded funds (ETFs) HYG and JNK offer wider spreads and less rate risk than the investment grade ETF LQD.
• We suggest an overweight position in high yield and market-weight or underweight in investment grade.

Credit Spreads Are Rangebound

As equities push higher despite headwinds (the debt ceiling, inflation, higher rates, weak consumer, etc.), investment grade and high yield corporate bond spreads remain within well-defined ranges. Investment grade spreads have been mostly near 135-150 bp after trading inside 100 bp during the euphoric period after the 2020 US presidential election; high yield is near 440 bp after trading near 300 bp in 2021.

Credit Spreads Follow Equity Volatility

So far, wider credit spreads show little sign that underlying credit fundamentals are deteriorating.

The primary driver of the credit cycle and credit spreads – the default rate – has been near 2% for the past 1.5 years (Chart 2). Defaults do happen – a recent example being the highly publicised and slow-moving train wreck Bed, Bath & Beyond (BBBY). But these remain idiosyncratic rather than systemic events.

The primary driver of credit spreads in recent quarters has been equity volatility, as measured by the VIX index of short-dated equity implied volatility (Chart 3). We once thought the VIX would follow credit spreads to the lows seen before the global financial crisis and the years before Covid, but it appears macro uncertainties have won out and credit spreads have moved modestly wider.

We Favour High Yield

For now, we see little risk of a major selloff in equities barring a major shock. The Federal Reserve (Fed) appears to be on or almost on hold, even though inflation shows little sign of dropping to below 3%. With a dovish Fed clearly prioritising full employment and keeping the economy gong, a recession is unlikely.

That said, rates are high enough to cause friction. Corporate earnings suggest consumers in the bottom half of the income spectrum are hurting. The only thing between them and recession is their job. Plenty of companies are doing well in the current environment, but plenty are struggling. Given these tensions, we expect equities to remain rangebound for now.

In this environment, credit spreads are also likely to remain in their current range. We expect credit spreads to move in line with the VIX until the credit cycle starts to deteriorate.

Investors who want to invest in corporate credit must either buy individual bonds or invest in corporate bond funds. Individual bonds are beyond our scope; we focus on funds, specifically ETFs. The primary investment grade ETF is LQD. In the high yield space, there is either HYG or JNK. HYG is larger, with a market cap of $17bn vs $8.3bn for JNK. Apart from that, both offer broad exposure to the high yield market.

The performance of LQD and HYG/JNK depends on both credit spreads and underlying interest rates. When Treasuries rally, investment grade tends to outperform because its duration (or average maturity) is longer. Likewise, when rates rise, such as during 2022, high yield, with a shorter duration, outperforms. Away from rate risk, high yield tends to outperform due to its wider spread.

We currently expect rates to be stable or rise modestly. That favours high yield over investment grade. We suggest an overweight in high yield (HYG or JNK) and marketweight or underweight in investment grade (LQD).

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.)