The Long and Short
Comparing risk compensation as spreads move towards historic tights
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 investment grade corporate bond index recently closed at +89, surpassing the 2020 tights and just 4 bp behind the post-crisis historic tights observed in February 2018. The high yield index is also pushing up against recent historic levels. While spreads threaten to move toward post crisis lows, and overall risk compensation for BBB vs single A risk is pushing toward historic tights, there are still opportunities for selective investors to be paid more generously for taking on the additional risk, by identifying how these relationships differ across sector and individual subgroups.
The spread relationship between the IG and HY indices is just about to pass the threshold of -1 full standard deviations versus the five year mean, which has not occurred since 2018 (Exhibit 1).
Exhibit 1. High Yield vs Investment Grade OAS
Source: Amherst Pierpont Securities, Bloomberg/Barclays credit indices
Likewise, the available risk compensation within the IG universe has already crossed over into recent historic tight territory. Despite the lingering economic threat of the ongoing pandemic and related shutdowns impacting the more cyclical corners of the global economy, the relationship between BBB-rated spreads and single-A rated spreads has already crossed the threshold of -1 full standard deviations versus the five year mean. Global demand for yield has offset the near-term operational weakness and fundamental credit concerns of the lower-rated segments of the IG the universe, even as some specific segments lag the broader recovery in credit (primarily airlines/travel/hospitality and retail).
Exhibit 2. BBB vs A-rated OAS
Source: Amherst Pierpont Securities, Bloomberg/Barclays credit indices
To gain a little more historic perspective of how investors are being compensated for BBB risk within the corporate IG universe, we take a closer look at two predominantly BBB-rated segments of the market in the financial sector. First, we look at the fair value for BBB-rated REIT credits across the curve to see how spreads compare with the broad IG Index today versus one year ago in Exhibit 3 below. Spreads are generically tighter than they were just one year ago for both BBB REITs and the IG Index. However, investors are being paid more now comparatively to trade into BBB REITs versus the rest of the IG index than they were a year ago – particularly in the 10- to 30-year part of the curve. This implies that investors are still well suited to maintain an overweight in the BBB REIT segment, even as overall spreads remain tighter versus this time in 2020.
Graph 3. BBB REITs (blue) vs Broad IG (red) – Current spread curves vs one year ago
Source: Amherst Pierpont, Bloomberg fair value curves
Similarly, we take a closer look at the fair value for BBB-rated Insurance credits in Exhibit 4, comparing the current curve against the broad IG universe today versus one year ago. Once again in this example we see that while spreads are tighter than they were a year ago, investors are receiving significantly more risk compensation to move out into BBB-rated insurance credits versus generic IG credit. This is particularly true in the 10- to 30-year part of the curve where available spread is considerably higher in BBB-rated insurance than it was just one year ago.
Graph 4. BBB Insurance (red) vs Broad IG (blue) – Current spread curves vs one year ago
Source: Amherst Pierpont, Bloomberg fair value curves
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