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An autoposy of the widening in IG credit
admin | December 7, 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.
The re-pricing in credit – which began in earnest at the beginning of October – widened spreads across the broad investment grade market by 30 bp, though some performance differences across sectors emerged. Energy did significantly worse as the price of oil tumbled, though the sector recently stabilized and could re-trace in-line with the broader market if OPEC’s latest production cut meaningfully reverses the decline in oil prices. On the upside, the traditionally defensive sectors of health care and consumer staples did suffer less in the sell-off, and the high-beta communications sector actually gained a bit of ground versus the overall market.
A broad-based sell-off
The broad market sell-off in spread products was arguably triggered by the melt-down in equities. As corrections go, so far the re-pricing in investment grade credit has been sharp but remains easily within the bounds of “normal” market spreads over the past two years, as shown in Exhibit 1.
Exhibit 1: Investment grade corporate credit spread index
Source: Bloomberg; US dollar investment grade all cash bonds sector option-adjusted spread index.
The equity rout washed over into corporate debt, and no sectors escape unscathed. The overall investment grade corporate market widened 36 bp from October first to December 7th on an option-adjusted spread (OAS) basis. The nominal changes in OAS of several sectors compared to the overall market are show in Exhibit 2. The broad market OAS (shown in Exhibit 1) was ~97 bp on October 1. The communications sector was 39 wider on a nominal basis at 136 bp, the energy sector OAS was 20 bp wider at 117 bp, and so on as shown in the graph.
Exhibit 2: Difference in OAS of sector to overall investment grade market
Source: Bloomberg; US dollar investment grade OAS by sector.
Historically utilities are the most defensive bonds to own as they tend to have the lowest beta to the overall market*. That did not prove to be a great hiding place this time around as sector-specific risk materialized due to the fires in California, which wreaked some havoc with west coast utilities. Overall the utility sector widened 30 bp over the same period, for a beta of 0.83. On the high side, the high beta energy sector inherited sector-specific risk of its own due to the decline in oil prices, and widened 49 bp from 117 to 166 bp, though it has shown signs of stabilizing over the past week, in-line with the price stability in crude thanks to the OPEC agreement to cut production. Health care and consumer staples both widened somewhat less than the overall market, slightly outperforming their betas of 0.9-1.0 on a risk-adjusted basis.
Consumer discretionary has an OAS slightly wider than the broader market but typically has a beta below 1.0. This was perhaps the worst performing sector as it widened 41 bp over the period, more than overall market, and was wider in late October during the depths of the sell-off in some automakers which dragged out the sector. The reverse occurred in communications – a traditionally higher beta name which actually outperformed during the overall sell-off, widening only 30 bp.
More volatility ahead
The credit markets continue to leak wider, though its possible all spread markets may stabilize somewhat if equities find their footing ahead of the FOMC meeting on December 19. The return of intraday volatility as the Fed removes forward guidance and becomes increasingly data dependent was expected and is clearly already occurring. The re-pricing is likely to continue into next year, but absent a significant economic downturn – which is difficult to see in the near term – a serious melt-down seems remote.
*Technical note: Calculating the betas of the sectors versus the overall market can be sensitive to what time period is chosen. Periods of low volatility or using short time frames can skew the numbers or relationships between the sectors. The betas referenced here are calculated over a 2-year time period prior to the current sell-off, though perhaps the most defensible analysis is to produce a rolling beta over a 1-year or 2-year window.
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