Credit | Economics & Growth | Monetary Policy & Inflation
Credit Outlook – Why Spreads Are Tight and What Will Drive Them Wider
- By John Tierney
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- 4 min read
Summary
- Pundits are again tilting at the frothy high yield credit market, saying spreads are too tight given rising rates and recession risks.
- They miss obvious fundamental reasons why credit spreads remain tight – default rates are low, and corporate balance sheets are in great shape.
- Further, credit (and equity) markets have been confident that the economy can withstand a terminal Federal Funds Rate (FFR) of 5-5.25%.
- Recent Fedspeak suggest that the terminal rate target could rise.
- Credit spreads will widen if higher rates cause EBITDA* and profit margins to fall below pre-pandemic levels.
Market Implications
- Credit markets see little risk of a major default cycle soon.
- Even if a significant recession happens, we think defaults will be lower than previous cycles because corporate balance sheets are in great shape.
- For investors who can tolerate mark-to-market volatility, we think current spreads more than compensate for likely default risk.
Introduction
Seemingly, several times a year, some pundit decides the high yield market is getting too frothy and needs a scolding. The New York Times, The Wall Street Journal, The Lex column of the Financial Times (and other various FT columnists) all do it. And the latest is FT alum and current Bloomberg blogger John Authers.[1]
He makes the usual point that credit spreads currently appear too tight given rising rates and recession risks (high yield spreads are near 400bp; investment grade is about 120bp). He argues that the normal strong correlation between tightening bank lending standards and high yield spreads has broken down (Chart 1). He points out that there appears to be relatively little discrimination between less- and more-risky balance sheets. Such conditions prevailed in 1H 2007 and everyone knows what happened in 2008-09.
* Earnings before interest, taxes, depreciation, and amortization
[1] This article is available to Bloomberg subscribers. It may be available at ‘Credit Spreads Puzzle May Hold a Hidden Message’.
In fairness, Authers does suggest that perhaps credit markets are telling us something. Maybe credit spreads are tight because underlying economic conditions really are less risky. He cites in particular strong consumer balance sheets as a source of support for the economy and corporate credit spreads.
However, consumer balance sheets are not corporate balance sheets. As anyone who has completed a basic statistics course knows, ‘correlation is not causation.’
Below are some of the underlying causes (as opposed to correlations) that explain why credit spreads are tight, and what this means for credit spreads going forward.
Low Default Rates Means Tight Spreads
First and foremost, credit spreads are tight because default rates are low (Chart 2). The trailing 12-month US high yield default rate has been wrapped around 2% since late 2021.
Credit investors are not stupid. When signs of credit stress start emerging (through rising rating downgrades or shrinking profits, and debt and interest coverage ratios), credit spreads widen – usually before rising defaults. And when the cycle starts to improve, credit spreads tighten well ahead of the trailing default rate. By historical standards, credit spreads today are arguably still wide given default rates. Investors are being more than compensated for ongoing default risk.
Credit spreads are also highly correlated with equity volatility (Chart 2).[1] The VIX has been near 20% recently. By this measure credit spreads do appear on the tight side and arguably could be closer to 500 bp.
[1] The intuition is as follows: Equity and credit can be viewed as options on the assets of the firm. Equity is effectively a long call option for investors. The strike is the purchase price; the investor receives the upside if the firm prospers, and loses no more than the initial investment if it goes bankrupt. Credit is a short put position for investors. They receive a premium in the form of a coupon. If the firm prospers the bond is repaid at par and the investor has no upside. If the firm goes bankrupt the assets of the firm are ‘put’ to investors, who are left with whatever the recovery value is – typically about 40% of going concern value. Equity volatility is a key input into option valuation. As volatility rises, the option premium (or spread) on credit rises.
The VIX does suggest there is some risk credit spreads could leak wider. But apart from low defaults another other factor that has kept spreads at tight levels is strong corporate balance sheets.
Leverage Ratios Are Stable
We examine basic credit metrics for the universe of companies in the HYG High Yield ETF, and non-financials in the S&P 500 (SPX). The HYG mostly holds BB and B-rated bonds, with some in the CCC cohort. The SPX is mostly large investment grade companies with an average rating at the high BBB level.
Pre-COVID-19-pandemic, debt/equity ratios rose for both high yield (HY) and SPX companies as debt grew faster than equity (Chart 4). But this added debt was covered by rising cash flow, as debt/EBITDA ratios remained stable (Chart 5).
concern value. Equity volatility is a key input into option valuation. As volatility rises, the option premium (or spread) on credit rises.
When the pandemic lockdowns hit business cash flow dried up for several quarters, causing debt/EBITDA ratios to spike. But since then, debt/EBITDA ratios have returned to pre-pandemic levels. Debt/equity ratios have been stable or even declining since early 2021.
The key point here is that both SPX and HY companies have been remarkably disciplined about adding debt, despite historically low rates that might have encouraged a leveraging binge.
In previous cycles, leverage ratios tended to creep up as the recovery matures, leaving companies vulnerable during major slowdowns or crises. Not this time – at least not yet.
Interest Coverage Is Near Peak Levels
The other key credit quality variable is interest expense and interest coverage ratios – where corporate credit shines. Due to rock-bottom interest rates, corporate America has drastically reduced its cost of debt (Chart 6). HY companies have cut the interest rate by 50bp to 3.6%. SPX companies now pay about 2.8%. Today, Treasury rates are in the 4% to 5% range depending on maturity.
Interest coverage ratios (EBITDA/Interest Expense) are over 14 for SPX companies and near 6 for HY companies – both above pre-pandemic levels.
In addition, companies have taken advantage of low rates to extend debt maturities. Long-term debt (maturing in more than one year) is about 88% for SPX companies and 93% for HY companies. It will be some time before most companies face significant debt maturities, and until then they have ample cash to cover interest expenses.
About Those Tightening Bank Loan Standards…
Returning to the tightening bank standards noted above, there are key differences between bank loans and corporate bonds.
- Bank loans are floating rate. The benchmark is the Prime rate, which is 7.75% – multiples of the cost of outstanding fixed-rate corporate debt.
- Bank loans (or credit lines) tend to have maturities of three years or less. Even if current loans carry lower rates, they are at risk of soon repricing to much higher levels.
Is it any surprise that banks are turning more cautious about lending standards even as high yield spreads remain tight?
The combination of low defaults and strong balance sheets is the ‘cause’ behind tight credit spreads.
What Lies Ahead?
Credit spreads are forward looking. That credit spreads remain tight implies that credit investors believe the Federal Reserve (Fed) will not push rates high enough to choke off the recovery and bring on the kind of recession that leads to significantly higher defaults.
Until the past few days, both the Fed and markets have targeted a terminal FFR of 5-5.25%. Whether that is sufficient to control inflation is uncertain. But both credit markets and equity markets have made it clear that this level should have little adverse impact on the economy or unemployment.
The risk for credit markets is that the Fed pushes rates higher until the economy slows and corporate cash flow and profits weaken. Leverage can rise either from adding debt – or losing the cash flow to support it.
Currently, EBITDA margins are off peak levels of the past two years, but still above pre-pandemic levels. If margins start eroding from present levels, that will be a big yellow flag for credit spreads, and will likely lead to wider spreads.
If the economy tips into a significant recession with rising unemployment and weakening profits, both HY and IG spreads will gap out in expectations of a significant wave of defaults or downgrades.
Credit Spreads Will Cover Likely Default Risk
Here is the surprise. Assuming companies remain disciplined about adding debt and do not go on a leveraging binge, as they have in the past, default rates will be much lower than in previous cycles, due to those robust balance sheets. As investors realize this, credit spreads will soon collapse.
For investors who expect the Fed to cause that recession eventually, should they continue holding IG and HY bonds? In our view, yes. If they can tolerate some mark-to-market volatility, current spread levels will be more than sufficient to cover credit losses.
Ultimately, the real risk is that some major crisis sets off a big default cycle. Few – including Authers – expect that scenario in the foreseeable future.
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.
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