The Long and Short
Falling net supply may be keeping spreads tight
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.
For at least the last several months, the par balance of the investment grade corporate bond market has declined. This is in part due to heightened maturities and redemptions, but also to a declining rate of growth for the par value of the market index. With current spreads only several basis points from the tightest levels of the year, it is conceivable that current valuations could be partially propped up by this negative net supply. Investors should at least consider the prospect that a return of the index to a more normal rate of growth could push overall spreads wider.
The simple relationship between index par value over time and spread shows very little (Exhibit 1). Ultimately, the amount of bonds outstanding in the index appears to have little if any directional influence on the direction or magnitude of spreads.
Exhibit 1: Steady growth in investment grade index balance, variable spreads
Source: Santander US Capital Markets LLC, Bloomberg LP
However, tracking rate-of-growth for the index over time looks more relevant to spreads. The 60-day percentage change in index par value, which effectively demonstrates the 3-month rate of change in par balance, is represented by the green line in the graphic below (Exhibit 2). It demonstrates that the rate of change over the past roughly three months is currently negative—only the fourth time in the last five years. This deceleration in the rate of growth could be creating negative supply pressure on the market, and therefore temporarily propping up spread valuations. Likewise, the year-over-year change represented by the blue line appears to be at the second lowest level recorded over the past five years.
Exhibit 2: Index Par Value Rate-of-Growth on a YoY (blue) and 60-day (green) Basis
Source: Santander US Capital Markets LLC, Bloomberg LP
Exhibit 3 below adds the option-adjusted spread (OAS) for the investment grade index depicted by the orange line. It demonstrates a rough correlation, that the 60-day rate of change for the index has dropped below 0% at roughly the same time spreads are right and then rises above 0% spreads at roughly the same time that spreads are wider. Although there are invariably a wealth of factors contributing to the direction and magnitude of spread changes over time, it is important to at least consider how market supply is influencing performance in the sector.
Exhibit 3: A rough correlation between index par growth and OAS
Source: Santander US Capital Markets LLC, Bloomberg LP
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