A steady steepening of the spread curve

admin | October 26, 2018

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

A steady rise in the amount of weaker investment grade credit and concern about its ability to weather any softness in the economy may finally be widening spreads to stronger parts of the market. The spread between longer ‘BBB’ and ‘A’ credit started the year around 40 bp but now stands just shy of 65 bp, with just under half the widening coming since the beginning of September. Since ‘BBB’ credit is now more than half of the outstanding investment grade market, the steepening spread curve should echo in other parts of fixed income.

The spread between longer ‘BBB’ and ‘A’ took a 10 bp leg wider in February around the same time that all corporate spreads widened. After meandering wider and then tighter through the summer, the spread has widened another 15 bp as other parts of the market arguably have signaled some economic uncertainty—a relatively flat yield curve in September and equity volatility in October.

Exhibit 1: A widening spread between ‘BBB’ and ‘A’ corporate credit

Source: Moody’s ‘BBB’ and ‘A’ spread indices, which are centered around 20- to 30-year maturity debt.

Although the increase in size and leverage in the ‘BBB’ corporate market continues to attract attention (Rising risk from BBBs), the steepening of the spread curve is the most relevant risk for other parts of fixed income. The spread curve between ‘BBB’ and ‘A’ CLOs has also steepened this year by 35 bp. The spread curve across the parts of the CMBS market with the most liquidity and easiest price discovery have steepened over the last month and stand to steepen further. Both CLOs and CMBS embed underlying corporate risk. In consumer assets, however, the steepening is harder to see—but price discovery deeper in the ratings stack arguably is cloudier, too. Very little steepening is apparent in single-family rental, for instance. Very little is obvious yet in broad parts of credit cards or autos. Consumer assets, however, depend on a generally robust household balance sheet where income, net worth and the ability to serve debt continue to look very strong.

Since the economy started growing in June 2009, a spike in equity volatility has slightly widened spreads before. More often than not, volatility has drifted lower, equity has recovered and spreads have regained some of the lost ground. Nevertheless, these episodes are valuable dry-runs for the point where the market finally sees fundamental economic slowing. We’re not there yet. But that may be next year’s story.

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The view in rates

The market continues to find reasons to drive yields broadly lower and slightly flatter, a very reasonable expectation when 10-year yields approached 3.25%. With yields now at 3.08%, the 10-year note looks very close to fair value. Neutral on duration sounds right for now. And the strategy of buying the 10-year as yields rise beyond 3.15% and selling as yields drop below 2.85% still seems like a good approach. Yields on the front end of the curve, however, look bound to keep rising. The last set of FOMC minutes continue to make clear the Fed’s intent to hike through most of 2019. The minutes included a clear discussion of potentially hiking through neutral into restrictive territory. Look for the curve to keep flattening from here.

The view in spreads

The corporate market has become the primary driver of spreads, and the trend looks wider with a steeper spread curve. Continued addition of leverage makes investment grade corporate debt riskier, and potential softening in GDP growth in the second half of this year only raises concerns. A drift wider in corporate spreads would likely pull agency MBS and other products along with it, although agency MBS would still likely benefit from investor interest in liquidity.

The view in credit

While the fundamentals of corporate balance sheets have some weak spots, they are harder to find on consumer balance sheets. Median household income is at a record along with household net worth, and household debt costs as a percent of disposable income are near a record low. If there is weakness, it’s in households with sizable student debt, and rising delinquencies in that asset signal that the debt is weighing heavily.