The Long and Short
The path of corporate bond spreads as the Fed tightens
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 Fed this week finally delivered its first rate hike since late 2018, moving the lower bound of the fed funds rate from 0% to 0.25%. The FOMC’s median dot plot shifted hawkishly, factoring in the likelihood of seven rate hikes for the remainder of 2022 and roughly catching up with market pricing. Cycles of Fed tightening since 1990 show how the investment grade corporate credit market has behaved. And history suggests corporate credit should do well.
Exhibit 1. Fed tightening cycles over the past 30+ years
Source: Amherst Pierpont, Bloomberg LP, Bloomberg/Barclays US Corp Index
There have been four tightening cycles since the beginning of 1990, all depicted in the gray shaded areas on Exhibit 1. All of the tightening cycles illustrated during this time period consist of six or more Fed rate hikes. A quick observation over history is that investment grade corporate bond spreads typically trend tighter during the earlier phases of rate hikes; which is somewhat intuitive as a period of tightening would likely be immediately preceded by a constructive period for corporate credit and relative economic stability. As the Fed gets further into their tightening schedule, bond spreads may become less predictable, and sometimes widen – after either brushing up against historic tights or seeing the environment for corporate credit weaken amidst rising rates.
The four more recent tightening trends depicted in the graph exhibit mixed behavior as rate hikes are implemented over each of their respective time periods. The first of these periods begins on February 4, 1994 with a rate move to 3.25% from 3.00% and concludes on February 1, 1995 with the fed funds rate peaking at 6.00%. During this roughly one-year period, investment grade corporate bond spreads moved mostly sideways, trading within a short band over the year and concluding with spreads slightly wide of where they started.
The second tightening cycle on the graph begins on June 30, 1999 with a rate move to 5.00% from 4.75% and concludes on May 16, 2000 with rates peaking at 6.50%. During this stretch, bond spreads moved mostly wider, in particular during the latter portion of the Fed’s activity to move rates higher. The investment grade corporate bond index moved from an aggregate option-adjusted spread of about 106 bp to 156 bp during this period.
Perhaps the most iconic Fed tightening to take place over the course of the past 30 years was the cycle almost immediately preceding the financial crisis. During this stretch, the FOMC took the fed funds rate from 1.00% on Jun 29, 2004 to 5.25% by June 29, 2006 over the course of 17 rate hikes during that two-year period. As is historically typical, spreads traded tighter during the earlier rate moves but then traded mostly sideways. The investment grade index traded within a fairly narrow band throughout the remainder of the cycle, until the first phase of the financial crisis struck and sent spreads spiraling wider.
Exhibit 2. The Fed’s most recent tightening cycle (2015-2018)
Source: Amherst Pierpont, Bloomberg LP, Bloomberg/Barclays US Corp Index
A closer look at the Fed’s most recent tightening cycle is depicted in Exhibit 2. There were nine rate hikes beginning on December 16, 2015 and concluding on December 19, 2018, moving the fed funds rate in aggregate from 0.00% to 2.25%. This particular cycle is worth noting, as investment grade corporate bond spreads had been moving mostly wider since mid-2014, reaching a peak only shortly after the first Fed rate hike was implemented. This is a similar dynamic to what is currently occurring, and could lend perspective on what lies ahead for corporate credit. Notwithstanding the heightened geopolitical risk, investment grade corporate bond spreads are poised to tighten over the course of the next several rates moves from the FOMC throughout 2022. During the 2015-2018 tightening trend, the investment grade corporate bond index produced an aggregate total return of 10.65% and an excess return (credit return net of Treasuries) of 8.27%. From the wide print for the corporate bond index on February 12, 2016 to the tight print on February 1, 2018, the index produced a total return of 10.95% and an excess return of 13.89%.
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