Putting spreads in context
admin | November 16, 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.
It helps to put the recent widening of credit spreads in context. For investment grade and high yield debt and leveraged loans, spreads and pricing sit close to the median marks of the last five years. If credit quality were constant over that stretch, then the market arguably would be close to fair value. But corporate credit has steadily weakened and fair value in spreads is almost certainly wider than where it sits today. Wider spreads in corporate debt will likely pull structured credit and other market spreads wider and steepen credit spread curves.
Investment grade and high yield debt spreads today sit almost right on top of their median levels for the last five years with prices in leveraged loans right on the median as well (Exhibit 1). Median spreads come in below their averages, of course, since aggressive widening in early 2016 pulls the average up. The same goes for leverage loan pricing, with the median sitting above the average and the average getting dragged down by the sharp price drops of early 2016 (Exhibit 2).
Exhibit 1: Spreads in corporate debt and leverage loans sit right on 5Y medians
Exhibit 2: Wide debt spreads and low loan prices in 2016 showed potential risk
Medians and averages make good benchmarks when all the other important things stand still – supply, demand and, perhaps most importantly, risk. Risk has definitely not stood still. The rise in investment grade leverage at this point is well told. The increase in covenant-lite leveraged loans is also well told. Corporate balance sheets in general are riskier, but risk needs something to trigger it. And that bring up the issue of the economy.
Spreads and prices on corporate debt over the last five years also reflect market expectations of the economy, and the economy in general has been good. The current expansion is one of the longest in the US since the end of World War II, even though growth has come in well below historic averages. The current issue with economic growth is how far below recent levels it might go. GDP growth in the second quarter of 4.2% is probably the high mark for the foreseeable future. The debate is whether growth will slow to a modestly high levels, to the pace just under 2.0% that the Fed expects or slip into recession.
The higher leverage in investment grade credit and the looser covenants in leveraged loans leave less room for corporate management to maneuver if the economy slows. Many management teams now plan to pay down debt with earnings, but a slower economy could get in the way of those plans. Corporations could stop share buybacks or cut dividends and use the cash to pay down debt. But that will require management to put the debtholder ahead of the shareholder, not the typical ordering. That’s the risk in the market. Not corporate credit alone. Not the economy alone. But both together.
With the intrinsic risk of corporate balance sheets higher than it has been and the path of the economy less certain than it has been, corporate debt should price wider in spread and lower in dollar price than the median levels of the last five years. That’s not a catastrophe. That’s rationale. And there’s no reason for now to expect spreads to run without reason to the levels of early 2016. For that, the market will need to see good reason to expect recession. We’re far from there for now.
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The view in rates
The strategy of buying the 10-year as yields rise beyond 3.15% and selling as yields drop below 2.85% still looks sound. With 10-year yield closing lately near 3.06%, duration looks like fair value. Go neutral on the long end of the curve. The curve still looks set to flatten, however. Look for the Fed to hike through most of 2019. Despite higher rates in the front end, the back end will still tend to price to 2% inflation and somewhere between 1% and 1.3% real rates. That pegs fair value for 10-year notes somewhere between 3.0% and 3.30%.
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 should 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.
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