Credit spreads are currently at their lowest levels since 2007. However, when accounting for the current economic cycle, monetary policy and corporate fundamentals, spreads potentially have more room to run.
Credit spreads are tight, but is it 2004 or 2007?
US corporate credit spreads are raising valuation alarm bells for many investors.
However, to us the scenario looks more like 2004 (where spreads were generally stable or even tightening), than 2007 (Figure 1).
Figure 1: Will spreads trend more like 2004’s tightening or 2007’s widening?1
The Fed's policies have distorted historical comparisons
We believe spreads today are wider versus history than they appear at first glance, given Fed policy.
The Fed’s corporate purchases changed the game
During the pandemic, the Fed purchased corporate debt directly for the first time, establishing a mechanism by which it can act as credit lender of last resort in extreme conditions.
This fact alone has potentially contributed an additional ~30bp of spread tightening (Figure 2).
Figure 2: The Federal Reserve’s implicit support in extremis has narrowed spreads by ~30bp2
Although the Fed’s credit purchase programs have since lapsed, markets take comfort from the establishment of this Fed credit ‘put’, potentially protecting the downside in future crises.
Central bank credit purchases during a crisis can potentially limit spread widening, thus making it easier for troubled issuers to refinance. As a consequence this can cause default rates to fall, in turn, reducing the spread compensation investors demand. This potentially creates a favorable feedback loop for investors.
The Fed’s wider asset purchases offer support today
The Fed’s QE programs (which began in 2008) have also changed credit market dynamics, by essentially reducing the purchasable supply of financial assets, thus creating upward pricing pressure across all asset classes.
Since the pandemic began, these purchases have accelerated, creating a ‘wall of money’ supporting bond markets. Since 2020, the Fed has expanded its bond holdings by $4.1trn, a full ~$1.5trn higher than the net volume of bonds created in the Barclays Agg over the same period (Figure 3).
Figure 3: The Fed’s ‘wall of money’ is impacting financial assets rather than the real economy3
Cash-rich balance sheets and low rates support today’s corporate fundamentals
Corporate fundamentals today may help justify historically tight absolute spreads, as issuers tend to be relatively cash rich.
At the height of the pandemic, corporates rushed to raise liquidity and term out debt. This, alongside other factors such as fiscal stimulus, helped contain corporate bankruptcies in 2020 (Figure 4).
Figure 4: US bankruptcies rose modestly during the pandemic4
Furthermore, corporate interest costs have fallen. Between 2004 and 2008, corporate all-in investment grade yields were 5% to 6%, versus 2% today. Even as corporate debt loads have risen, corporate interest costs to GDP have halved since 2007 (see Credit has little to fear from inflation).
Economic conditions indicate we are mid-cycle rather than late-cycle
As the US economy reopens, it is progressing into what appears to be a 2004-style ‘mid cycle’ phase of the expansion rather than the late-cycle 2007.
GDP growth is currently being driven by the consumer, a result of pent up savings and demand. We expect growth to continue into 2022 driven increasingly by public and private sector investment, a result of fiscal stimulus and rising corporate R&D.
We also believe we still have some way to go before we reach the ‘late’ cycle. Several areas of the economy still need to recover, such as retail inventories, exports and employment (Figure 5).
Figure 5: We may yet have some way to go to reach the late-cycle5
As such, while we just had the shortest recession in history6, we do not expect it to lead to the shortest expansion. We believe worry about the economy being late in the cycle could begin toward the end of 2022 and into 2023, when we project the unemployment rate to fall below pre-COVID levels.
Playing a relatively tight credit spread market
We believe investors need to retain a core allocation to investment grade credit to retain the carry available. However, we believe there are three key considerations.
1. Some sectors may reach late cycle faster
Housing, autos and related sectors such as durable goods have outperformed their pre-crisis trend levels, a product of the large ‘echo boomer’ contingent of the millennial generation taking the opportunity to buy houses in the suburbs.
Although demographics and a recent history of depressed housing construction may mean continued support to the market, investors may wish to begin exercising caution within these sectors, paying close attention to security selection.
2. Intermediate duration credit may benefit from technical support
Investors may wish to shift their credit allocations to areas with the most technical support. Increasingly, intermediate duration corporate bonds appear to fit the bill as pension liabilities shorten (with corporate DB plans increasingly closed to new members) and pension investments to shift towards slightly lower-duration assets.
This trend may also support other lower duration fixed income sectors, such as high yield credit and structured credit.
3. Be opportunistic in the event of volatility or market sell-offs
Day-to-day noise may result in intermittent credit market volatility. In many cases, this may provide opportunities for long-term investors to deploy cash opportunistically.
Looking ahead, we believe investors need to closely monitor economic conditions and monetary policy and view credit spreads through that lens. In our view, this will make it clearer to understand when conditions are changing, and conditions look more like 2007 than 2004. However, we do not believe conditions today are ‘too tight’.