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AAM Viewpoints – Corporate Credit Spreads Trading at Tightest Levels Since 2007


Risk assets remained in vogue last quarter as investors bid up prices seemingly across the board on stocks and corporate bonds while risk-free U.S. Treasuries sold off as the yield on the 10-year U.S. Treasury went up 20 bps (basis points) from 2.86% to 3.06%. The Corporate component of the Bloomberg Barclays Aggregate Index was up 0.97% in the third quarter while the U.S. Treasury component was down 0.59%. Among factors contributing to the move, 2nd quarter GDP increased 4.2% while the 3rd quarter is estimated to be tracking at 4%, the stock market continued to rise over 7% during the quarter while reaching new highs and credit spreads in the corporate bond market tightened. In 2018 investment grade and high yield credit spreads have reached their tightest levels in 10+ years.


A credit spread is the difference in yield between a risk-free asset (i.e. U.S. Treasury bond) and another debt security with the same maturity but of lesser credit quality. Credit spreads between U.S. Treasuries and other bonds are measured in basis points with a 1% difference in yield equal to a spread of 100 bps.


The chart and graph below illustrate the changes in High Yield, Triple-B and Double-A rated bond spreads going back to 2007.



Source: AAM; Federal Reserve Bank of St. Louis data



What drives credit spread changes? Early studies by Black and Scholes (1973) introduced “structural” models to explain corporate default risk and inspired the search for company-level and macro variables such as stock volatility, company leverage, and interest rates that could influence credit spreads. Favorable credit conditions along with a favorable economic backdrop, reasonable equity market valuations and positive momentum are keeping investors engaged in risk-taking though this could change should credit conditions deteriorate.


In the investment grade market, the average option-adjusted spread of the ICE BofA Merrill Lynch BBB Index tightened 12 bps in September and was 22 bps tighter in the third quarter at 141 bps, its lowest level since reaching 115 bps in February of this year. In the high yield market, the BofA Merrill Lynch High Yield Master Index tightened 25 bps in September at 324 bps, which is 47 bps tighter than at the end of 2017. This is the tightest level the high-yield index has registered since before the financial credit crisis. The tightest that the investment-grade index reached since the beginning of 2007 was 115 bps (also reached early this year), and the tightest the high-yield index registered was 241 bps.


We feel the tightness of spreads, or the low reward an investor receives for taking on additional credit risk is not adequate in many cases. We also feel the high yield corporate bond market is flashing warning signs. Excessive leverage, relaxed covenant protection and low yields are telling us to look at adding exposure in higher quality credits.


Although we believe the current cycle could extend through 2019, the end of a business cycle can be challenging as investors pay up for less yield as the amount of risk increases while the reward decreases. (Navigating Market Cycles) During these late innings, the amount of leverage on new issue loans moves up while the “protective covenants” drop. We are already seeing a higher percentage of covenant-lite loans and these covenants are the provisions in the bond indenture that are designed to protect bondholders from certain events that may happen to the issuer.


Signs of what could cause a reversal are limited and difficult to pinpoint, making it challenging for investors to choose the proper time to exit. Regardless, taking profit off the table and opting for higher quality credits may make sense given the potential quickness of a reversal versus the length of time it takes for credit spreads to narrow. We may see tight credit spreads for another few years before spreads widen, but when they do there can be significant volatility.


Understanding the history behind credit spreads allows investors to make more informed decisions about portfolio positioning. Hiring a professional management team with an experienced track record can help clients sleep at night during this stage of the cycle. Active managers often diversify portfolios across asset classes, sectors, maturities and tactically adjust duration as needed. Our playbook is telling us to evaluate opportunities to bring in duration, tighten credit quality, beware of tight spreads, increase exposure to Treasuries and Agencies, review Corporate exposure, and stress test portfolios. This approach allows fixed income investors to stay invested in volatile markets and provides a ballast to equity exposure in your portfolio.


 


CRN: 2018-1002-6924 R


This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.

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