What Are The Credit Markets Telling Asset Allocators? by Toby Nangle, Columbia Threadneedle Investments
- Credit spreads can contain important information about investors’ expectations regarding risks to corporate solvency, and the economic cycle more generally.
- Rising credit spreads can also reveal strains in the financial system that are only later reflected in equity market valuations.
- We explain what the signals in the recent sell-off tell investors and what we are doing with this information in portfolio construction decisions.
Credit spreads – the additional yield promised to investors over and above the yield offered by similar maturity government bonds – can contain important information about investors’ expectations regarding risks to corporate solvency, and the economic cycle more generally. Rising credit spreads can also reveal strains in the financial system that are only later reflected in equity market valuations. As such, it is worth asking what the substantial rise in Investment Grade and High Yield credit spreads over the past 18 months (figures 1 and 2) means for investors.
Credit spreads compensate investors for a combination of underlying corporate credit risk and illiquidity risk. We have written before about a technique that is used by our investment team and the Bank of England to split credit spreads into these two components. Our analysis suggests that there has been neither an increase in theoretical liquidity risk premia embedded in credit spreads, nor an increase in empirical measures of illiquidity over the past 18 months.1 As such it would seem by process of elimination that the increase in credit spreads really is about an increase in perceived credit risk.
The increase in credit spreads has come at a time when many energy companies have experienced a very marked deterioration in their prospects. Energy is an important part of the US high yield market, accounting for around 16% of the face value of the market.
Figure 3 compares the distribution of spreads for US high yield non-energy company bonds at the end of July 2014 when the oil price stood at $98 a barrel and September 2015 by which time the oil price had fallen to c$45. We can see that substantial distress has been priced into energy company debt when we repeat the exercise for energy companies, the results of which are shown in Figure 4. This shows that we have moved from a situation where virtually no US energy company bonds traded with an option-adjusted spread above 1,500 basis points to one in which more than 15% of energy company bonds (by face value) traded with this risk premium.
Importantly, the centre of gravity for both energy and non-energy high yield bonds has also shifted higher over the period, reflecting the fact that almost every sector of the market has been repriced (downwards). And interestingly, we find that the European high yield market has also been largely repriced despite its much lower exposure to energy (as shown in figure 2). It appears to be a victim of contagion in credit markets, and while we expect the default rate to spike higher in the US market, we are looking for no such default spike in Europe.
This increase in corporate credit spreads has also accompanied a rise in corporate gross debt to EBITDA (a widespread measure of leverage), and a dip in EBITDA-to-interest cover, albeit from extremely high levels. Putting all these pieces together it certainly looks as though there has been a change in the corporate landscape that has spooked credit investors.
But, as we dig a little deeper into what credit markets are telling us, this clear picture begins to blur. When corporate credit markets become concerned about near-term solvency risk, this becomes evident in two distinct ways. On the one hand corporate yield spreads rise (as we have seen this cycle). But at the same time corporate spread curves tend to flatten and invert – that is to say that investors demand more spread for short-dated bonds compared to longer-dated bonds.2 Away from CCC-rated credit, there is little sign of credit spread curve flattening – in fact the opposite appears to be happening. Figure 5 shows the spread curve steepness in a variety of US investment grade sectors which have each reached their steepest levels in 20 years. The picture at the upper end of the high yield market is more nuanced, but the warning signs associated with elevated spreads are so far absent (see figure 6). Some commentators have pointed to elevated long-dated corporate bond issuance as a driver of steeper spread curves. But while higher levels of issuance have recently coincided with steepening, we find no stable correlation between curve shape and issuance trends over the last 20 years and so find such arguments inconclusive.
So, what does this mean for investors?
Firstly, it makes us cautious in inferring a marked deterioration in prospective corporate solvency risks. If heightened solvency risks are foreseen by credit investors we would see higher short-term credit spreads, when in fact it is longer-term credit spreads that have increased the most. So rather than flashing two red lights, credit markets are flashing one red light (the level of spreads) and one green light (the steepness of spread curves). Investors seem relatively certain about the good near-term prospects of the market in general but have heightened uncertainty about credit conditions further into the future. This is true for both European and US credit markets.
Secondly, the heightened uncertainty associated with wider credit yields has been sufficiently powerful to have challenged equities’ status as the asset class with the most elevated risk premium. Figure 7 shows US high yield credit yields (dark blue line) against global equity earnings yields (based on 12 and 24-month forward consensus earnings expectations). This shows how rising credit yields have historically coincided with rising equity earnings yields (falling PE ratios, typically associated with stock market falls). The recent stock market fall coincided with the latest spike higher in high yield corporate bond yields – taking these higher than one-year and two-year global equity earnings yields for the first time since the Global Financial Crisis, and undermining the equity market’s status as the highest-yielding risk market. Investors are left with asset markets containing elevated risk premia across the piste, which makes for a more constructive investment environment, but also diminishes the attraction of equities as an asset class.
Informing this rise in uncertainty are three big themes about which we have recently written: the cyclical strength of the US economy in the context of weak labour market productivity; the oil supply shock; and questions regarding China’s economic rebalancing away from investment and heavy industry and towards services, combined with recent changes in Chinese authorities attitude towards currency policy.3 As such, we have not increased portfolio risk in any dramatic way, but have taken the opportunity to rotate our risk budget to take in more European high yield exposure in the Threadneedle Dynamic Real Return and Threadneedle Global Asset Allocation strategies.
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