The Big Idea
A tenuous tightening in credit
Steven Abrahams | April 8, 2022
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.
Credit has had a good run since the Fed’s March meeting. After widening from the start of the year into the meeting, Bloomberg’s cash index investment grade spreads have since tightened on average by 30 bp and high yield by 65 bp. The price on the average S&P/LSTA leveraged loan has rebounded by $2.12. Equity markets have bounced in concert, with the S&P 500 up by 5.3%. And it is through the lens of the equity market that the tightening in credit looks tenuous.
Even though equity and credit have different claims on the aggregate US corporate balance sheet, they inform each other. Equity only gets the leftovers after paying debt. But equity, as Merton argued, can always turn over the company to debtholders if the value of the company drops below the nominal balance of debt. Debtholders have written a put option to equity. As the value of the company and its equity falls, the put comes closer to in-the-money and should be more valuable. That should get reflected in wider debt spreads. As equity rallies, of course, spreads should tighten.
That is almost always the case. Equity and high yield show the clearest link since high yield has close exposure to the equity put. Equity prices and high yield spreads generally run in the expected direction, with higher equity prices driving high yield spreads tighter and lower prices driving spreads wider (Exhibit 1).
Exhibit 1: Equity prices and credit spreads move in synch
The recent rally in equity has left that market at the richest level in a decade based on the risk compensation left after covering the cost of inflation and real interest rates. One important benchmark of equity valuation is the ratio of projected earnings to equity price—in other words, the projected earnings yield on equity. This is better than the dividend yield on equity because forward net earnings reflect true expected equity returns, not just returns paid out through dividends. It is important to look at the spread between projected equity yield and longer interest rates. That helps break down the projected equity yield into an equity risk premium, compensation for inflation and compensation for the real interest rate.
Since March the compensation for equity risk left after covering the cost of inflation and real rates has tumbled (Exhibit 2). The projected 1-year earnings yield on the S&P 500 closed Friday at 5.51%. That yield needs to cover 2.88% of inflation implied by the closing spread between 10-year notes and TIPS and a negative 0.17% real rate, leaving only 2.80% compensation for equity risk. That is the single lowest equity risk premium in 10 years.
Exhibit 2: Equity looks rich, with the lowest risk premium in 10 years
It is far from clear why risk premiums should go down in this market. The Fed is in the early stages of an inflation fight that the March minutes acknowledge involves significant uncertainty. The beginning of QT should raise, not lower, risk premiums. The implications of the Russia-Ukraine war for the economy are only beginning to be parsed. It seems unlikely that valuations in equity can go much higher, at least based on risk premium, and could easily go wider. Credit spreads should follow. The good run in credit since the March Fed meeting looks suspect.
Investors have plenty of ways to manage the risk of wider spreads, most easily by moving up in quality in credit. Corporate balance sheets generally are strong, so investors have a wide set of good choices. And investment grade balance sheets in particular have extended the maturity of their funding and have ample protection against higher rates and slowing growth. It is time to take advantage.
* * *
The view in rates
The rates market continues to reprice to higher yields, although the longer end of the curve is starting to trade wide to fair value. The curve should invert significantly over the next year with 2-year rates around 3.0% or higher and 10-year rates around 2.5%. Persistent supply and trade frictions from Russia-Ukraine could force the Fed to go higher than currently priced and push the 2-year note toward 3.5%. Friday closing rates on 10-year and longer Treasury debt at 2.70% and higher look like the wide end of fair value—more than enough to compensate for likely 2% inflation and 0.5% in real rates.
The Fed’s RRP balances closed Friday at $1.75 trillion, up $84 billion in the last week. The RRP rate after the March 16 FOMC rose from 5 bp to 30 bp, and the race is on to see if banks raise rates to defend their deposit base or let deposits flow into money market funds and on to the RRP. So far, that seem not the case.
Settings on 3-month LIBOR have closed Friday at 99 bp, up 3 bp in the last week. Setting on 3-month SOFR have drifted up to 78 bp, up 10 bp in the last week. The spread between 3-month LIBOR and SOFR has tightened in the last few weeks after initially widening after Russia’s February 24 invasion of Ukraine.
The 10-year note has finished the most recent session at 2.70%, up 32 bp in a week. Breakeven 10-year inflation finished the week at 289 bp, up 32 bp on the week. The 10-year real rate finished the week at negative 18 bp, up 25 bp from a week ago. Real rates increasingly anticipate an aggressive Fed will drain the system of an overhang of cash supply.
The Treasury yield curve has finished its most recent session with 2s10s at 19 bp, steeper by 26 bp in the last week, and 5s30s inverted by 3 bp, steeper by 10 bp over the last week.
The view in spreads
Spreads still look broadly biased to widen. Repricing since the March FOMC has taken sizable risk out of the market although plenty remains around inflation and the Fed path. And Russia-Ukraine remains. Of the major spread markets, corporate and structured credit is likely to outperform, as it has generally since March 2020. Corporates benefit from strong corporate fundamentals and from buyers not tied to Fed policy. The credit markets have a diversified base of buyers while the only net buyers of MBS during pandemic have been the Fed and banks.
The view in credit
Credit fundamentals look strong for now but will almost certainly soften later this year as the Fed dampens demand and growth begins to slow. Russia-Ukraine should have limited direct impact on either the US corporate or consumer balance sheet. Corporations have strong earnings, good margins, low multiples of debt to gross profits, low debt service and good liquidity. It will be important to watch inflation and see if costs begin to catch up with revenues. A higher real cost of funds would start to eat away at highly leveraged balance sheets with weak or volatile revenues. Consumer balance sheets look strong with rising income, substantial savings and big gains in real estate and investment portfolios. Homeowner equity jumped by $3.5 trillion in 2021, and mortgage delinquencies have dropped to a record low.