Spread markets put trade to the side
admin | January 10, 2020
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.
The spread markets have started this year as if trade tension never occurred. Spreads on agency MBS, investment grade and high yield credit and CLOs, among other things, have tightened back to levels last seen just before talks on US-China trade broke down. The rates markets, however, still look nervous. And the rates markets seem right.
Aggressive tightening in the fourth quarter
Almost all the tightening came after September as the US and China seemed to look for ways to avoid scheduled December 15 tariffs. Agency MBS tightened 9 bp while investment grade credit tightened 26 bp (Exhibit 1A). High yield credit tightened 63 bp and ‘BB’ CLOs tightened 36 bp.(Exhibit 1B). They all stand roughly around levels of early May before US-China talks broke down.
Exhibit 1: Spreads have tightened back to early May 2019 levels
Source: Amherst Pierpont Securities
Rates, meanwhile, have not shown the same courage to look through trade risk. US 10-year yields have move up 20 bp since the end of September but still stand 66 bp below their May level. US 2-year rates have dropped 6 bp since September and stand 73 bp below May’s marks.
It is high art to read the messages sent by markets, especially large ones subject to influence from multiple directions, but credit seems too optimistic. Trade and tariffs increasingly have become a form of geopolitics by other means. That seems like one of the clear lessons of last year. Beyond the risk of a fresh round of trade conflict in 2020, corporate leverage in investment grade corporate debt and leveraged loans especially is high, leaving limited room for error.
Investors that rode the tightening in credit through the end of the year should take advantages of January’s continuing rally to lighten up on positions. There is a very good chance of being able to reinvest at wider spreads later in the year.
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