Why Credit Spreads Are Resisting Threats From Rising RatesBy
Negative correlation between rates/spreads in previous cycles
High-yield debt offers price cushion; real rates a risk
Credit markets didn’t get the memo.
After hawkish rhetoric two weeks ago by central bankers led by Mario Draghi set off a sharp surge in government bond yields, the investment-grade and high-yield debt markets have collectively shrugged.
Since then, the extra compensation investors demand to hold high-yield bonds around the world over similar-maturity government debt has increased by a whisker at five basis points, according to the Bloomberg Barclays Global High Yield index, while spreads on high-rated debt in euros and dollars have tightened -- now sitting near post-crisis lows.
If markets are braced for a new dawn for risk assets bereft of monetary stimulus to juice returns amid record U.S. corporate leverage, credit investors remain remarkably sanguine. That’s in contrast to the tantrums of 2013 and 2015, when the fear of a fading central bank put triggered a disorderly selloff across debt markets.
Investors are betting on policy perfection: the removal of monetary stimulus in tandem with expanding output, moderate inflation, and a healthy debt-servicing outlook for corporations in the U.S. and Europe that will juice returns on credit.
“If rates are rising because growth is strong and risk appetite is firming, then spreads can tighten,” said Marty Young, strategist at Goldman Sachs Group Inc. “If rates are rising because of an unexpected hawkish shift in policy -- as in the 2013 U.S. taper tantrum -- spreads tend to widen.”
This logic isn’t wishful thinking, strategists and investors say -- it’s backed by decades of history.
A Goldman Sachs analysis shows that bonds, especially from high-rated companies, have historically had a negative correlation with U.S. Treasury debt, while BB-rated securities are more sensitive. In other words, rising Treasury yields in the past have been offset by tightening spreads, while coupon income has boosted returns as rates rise.
The inevitable retort: this cycle couldn’t be more different. “We have artificially low rates, low growth, and tight spreads because credit offers a pick-up versus government bonds -- that’s a whole new ball game,” said Suki Mann, founder of bond-market analysis firm CreditMarketDaily.com.
“With spreads already so tight the distribution of potential outcomes seems rather lopsided to us,” Citigroup Inc. strategists led by Hans Lorenzen note. Economic growth, as implied by inflation expectations and interest-rate markets, doesn’t justify the level of optimism in credit markets, they say, noting that subdued price pressures haven’t yet bitten investors.
“There might be times when everything sells off at the same time, rates go higher, spreads go wider,” said Chris Iggo, head of fixed-income investment at AXA Investment Managers. But barring market dislocation, he reckons high-yield can hold its own in a rising rate environment, noting that rising Treasury yields historically have set the stage for the outperformance of riskier parts of the bond market.
Junk obligations, which tend to have shorter maturities than high-grade debt, have stronger cushions for interest-rate risk and, as such, have typically outperformed when Treasury yields have advanced more than 100 basis points, according to research from asset management firm Lord Abbett & Co. While Treasuries posted a 5.8 percent loss in the year to May 2006, for example, high yield bonds notched a 4.7 percent gain, their research shows, noting similar cases in 1994, 1996 and 2010, among other years.
What’s more, barring a policy mistake, expanding output should boost corporate earnings and offset the negatives from an uptick in refinancing costs, according to analysts. “The primary, direct driver of default rates is not the yield on Treasury bonds but rather the business cycle,” said Martin Fridson, chief investment officer of Lehmann Livian Fridson Advisors LLC, in a note.
In short, while rising rates will eat into total returns, markets, for now, don’t see an imminent threat to credit spreads or to the excess returns over government yields garnered from debt issued by companies with strong and fragile balance sheets alike.
Bank of America Corp. reckons high-yield bonds are set to outperform investment-grade debt as central banks increase the supply of the latter to downsize balance sheets. Goldman Sachs, meanwhile, said regulatory reform will allow investors to take more leverage, especially via repurchase agreements, known as repo markets, boosting the allure of high-rated debt over junk obligations.
The line in the sand to look out for credit bulls? Possibly a notable uptick in volatility, or a material increase in interest rates adjusted for inflation.
“We would need much, much higher rates on the back of higher growth and inflation, then I would think that the positives derived from the boost to credit fundamentals would be outdone by the potential for rotation from credit to equity as investors chase capital-appreciation strategies instead of capital-preservation ones,” adds Mann, a former head of credit strategy at UBS Group AG.
The prospect that the credit party will continue in earnest, in defiance of monetary tightening, will be more food for thought for central bankers faced with the conundrum of ever-looser financial conditions.