The Long and Short

Financials still show promise of spread compression

Dan Bruzzo, CFA | January 5, 2024

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.

Much of the excess return to credit lately has come in the rally that dominated the fourth quarter last year. But total return was more of a round-trip for most sectors with roughly the midpoint of the year marking an inflection point for overall performance. For now, within the investment grade corporate sector, financials still hold the most capacity for spread compression based on ranking current spreads compared to their distribution over the last five years. In fact, banks represent the only sector that is trading wide to its five-year median.

In exhibit 1 below, the broad fixed income asset classes are demonstrated by lowest to highest excess returns for 2023. The investment grade corporate index came in third place with an excess return of 4.39% behind both EM USD sovereigns (5.33%) and high yield (8.60%). Total return of 7.82% also came in third behind those two segments, despite IG maintaining the highest duration (7.05) of any of the broad asset classes in the study, demonstrating that overall relative performance for the full-year may have been driven more directly by credit performance than exposure to rates. MBS, CMBS and ABS made up the bottom performing segments in the market throughout last year. Also worth noting, is that this very basic re-cap fails to capture the variability of returns throughout the year.

Exhibit 1. 2023 excess and total returns by broad fixed income asset class

Source: Santander US Capital Markets LLC, Bloomberg/Barclays Banking Indices, index duration in parentheses

In exhibit 2 below, each broad fixed income segment is listed by their current five-year spread percentile ranks, with current OAS for each demonstrated as well. Not surprisingly, the three top performing segments all appear to be the “richest” with regard to where OAS currently ranks along their respective five-year trading histories. With the IG corporate bond index OAS teetering on the +100 level throughout this week, it does appear there is limited capacity for material spread compression (in aggregate) as we enter the new year, with the asset class poised as more of a carry trade opportunity, particularly relative to the various classes of structured products.

Exhibit 2. 5-year spread percentile ranks and OAS by broad asset class

Source: Santander US Capital Markets LLC, Bloomberg/Barclays Banking Indices

Exhibit 3 below drills down a layer deeper into the performance of the sub-categories of each asset class throughout 2023, with the same metrics of excess and total return demonstrated on the chart. HY financial (10.10%), HY industrial (8.53%) and EM LATAM (6.92%) delivered the three highest performances of the year by credit return, while MBS fixed (0.52%), ABS credit card (0.76%) and ABS other (0.90%) delivered the worst. Perhaps among the more surprising elements of this exhibit is that IG financials (3.77%) delivered a mid-tier performance relative to broader asset class sub-categories, despite what was among the weakest aspects of the IG corporate market.

Exhibit 3. 2023 excess and total returns by fixed income asset class sub-categories

Source: Santander US Capital Markets LLC, Bloomberg/Barclays Banking Indices, index duration in parentheses

Exhibit 4 demonstrates the five-year spread percentile rankings of these same sub-categories as the new year begins. The top six positioned of the market are all among the segments of structured products that largely underperformed throughout 2023. Meanwhile, the absolute lowest score recorded in the study is among IG industrials, which at 12% suggests extremely limited capacity for spread tightening as the new year begins.

Exhibit 4. 5-year spread percentile ranks and OAS by broad asset class

Source: Santander US Capital Markets LLC, Bloomberg/Barclays Banking Indices

Shifting focus specifically to the IG corporate sector, exhibit 5 demonstrates excess and total returns by individual sector for 2023. The top five performers included communications (6.20%), finance companies (5.60%), basic industry (5.48%), energy (5.36%) and life insurance (5.24%). Meanwhile, not at all surprisingly, banking (3.41%) was the single lowest performer in the IG index amidst the regional bank crisis and fallout that largely drove credit throughout all of last year. Again, even within the corporate sector, this demonstration of performance does not account for variability of returns throughout the year, but rather depicts the full-year performance in aggregate.

Exhibit 5. 2023 excess and total returns by IG corporate sectors

Source: Santander US Capital Markets LLC, Bloomberg/Barclays Banking Indices, index duration in parentheses

When looking at the IG five-year spread percentile ranks, it is not surprising that financial sectors make up the bulk of the highest scoring segments of the asset class, but only banking (58%) scores above its five-year average level with the rest the rest falling below the 50% threshold. Financials do appear poised for outperformance relative to industrials and utilities, and should be overweighted to begin 2024, but within the limitations of the broader asset class’ expected performance.

Exhibit 6. 5-year spread percentile ranks and OAS by IG corporate sector

Source: Santander US Capital Markets LLC, Bloomberg/Barclays Banking Indices

The last drilldown in the study is to look at 2023 performance by industrial subsectors. Largely, the higher duration components of the industrial segment did appear to outperform both on an excess and total return basis, with elements of communications, energy and basic materials among the top performers throughout last year. However, as the percentile spread rankings in exhibit 8 indicate, the sector itself appears less likely to experience material spread compression in the coming year than other segments of the broad IG market. Within that context, some select areas that appear poised for some degree of relative outperformance include autos, media entertainment and airlines.

Exhibit 7. 2023 excess and total returns by IG industrial subsectors

Source: Santander US Capital Markets LLC, Bloomberg/Barclays Banking Indices, index duration in parentheses

Exhibit 8. 5-year spread percentile ranks and OAS by IG industrial subsectors

Source: Santander US Capital Markets LLC, Bloomberg/Barclays Banking Indices

Dan Bruzzo, CFA
dan.bruzzo@santander.us
1 (646) 776-7749

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