Don’t Stress, Credit Isn’t - Yet
April 2019
On the heels of a dovish about-face out of the FOMC and some less than encouraging economic data, broadly speaking, yields in the 2 to 10-year portion of the Treasury yield curve descended at breakneck speed almost daily from the beginning of March through month-end. The 2-year yield fell 25 basis points during the month while the 10-year declined 22 basis points, boosting returns for investors willing to take on interest rate risk (duration) at the end of February. The rally in Treasuries propelled the Bloomberg Barclays U.S. Aggregate Bond Index to a 1.9% return during March, and a 2.9% return year-to-date. While bonds with safe-haven characteristics, i.e. Treasuries, have rallied sharply, one might have expected riskier bonds to be a source of funds as economic growth expectations have been lowered, but that has been far from the case.
At the index level, credit spreads for both investment-grade and high yield corporate bonds remained steady throughout the latest bout of economic uncertainty and recession talk. The option adjusted spread (OAS), or required compensation for taking on credit risk, for the Bloomberg Barclays U.S. Corporate Index over the Treasury curve collapsed down to 119 basis points at the end of March from 153 basis points at the end of December, generating a 5.1% return during the first quarter of 2019. The Bloomberg Barclays U.S. Corporate High Yield Index has fared even better, with that particular Index’s OAS dropping from 526 basis points to start the year down to 391 basis points to close March – all told generating a 7.2% return during the quarter. While we just threw out a whole bunch of numbers, all of which likely mean little without being placed in proper context, simply put, spread compression across the credit spectrum has failed to confirm more Draconian views of the global economic backdrop being espoused by some due to the inversion of the yield curve between 3-month and 10-year instruments.
Credit spreads can be an early warning sign of impending economic and equity market stress, often blowing out at the slightest hint that corporations may not be able to meet debt repayment obligations - but few such signs exist right now. While the economic backdrop may appear to be less than ideal at the present time, corporate credit spreads lead us to the conclusion that liquidity is ample, financial conditions are supportive, and investor appetite and demand for riskier bonds remains strong. With Treasury yields trending lower into month-end and credit spreads stable, it’s difficult to find significant value in bond-land at the moment. We favor emerging markets debt, both U.S. dollar denominated and in local currency, for diversification and its higher expected total return. Selectivity across asset-backed bonds, specifically MBS and ABS, is more crucial now than coming into 2019 as the sharp move lower in interest rates raises the probability that a many securities issued within the past couple of years are refinanced, with investors scrambling and moving out on the risk spectrum to find comparable yields. With the recent rally in high yield bonds, we find ourselves closer to the exit, with a decision on trimming or eliminating our position there a possibility over the coming months.
Source: Bloomberg, Factset
