Is a widely followed barometer of mounting pressures in the economy and financial markets losing some credibility on Wall Street?
Monitored by investors as a gauge of bearish sentiment swirling around the economy, credit spreads have maintained a tight range in recent months, despite a number of factors that many investors think should have driven them wider.
Notably, the spread between yield on U.S. high-yield corporate bonds, otherwise known as junk bonds, and Treasurys, marks the premium investors demand to hold risk-free U.S. government paper versus the higher risk of nonpayment from corporate borrowers.
An explosion of long-dormant stock-market volatility earlier this year, a potential trade war between China and the U.S. and slowing momentum in global growth., should have, in theory, sent these credit spreads wider. That would have come as investors sold riskier corporate bonds, sending yields higher, while fleeing to the safety of Treasurys, driving their yields lower. Yields and bond prices move in opposite directions.
Instead, the differential between riskier high-yield corporate paper and government bonds remained stuck in a range.
Indeed, while the S&P 500 SPX, +0.50% and Dow Jones Industrial Average DJIA, +0.76% tumbled in to correction territory back in February, defined as a drop of at least 10% from a recent peak, investors have continued to scoop up high-yield corporate debt. With both considered risky assets, high-yield bond spreads and equity prices have historically moved in tandem.
Credit spreads for junk bonds, as measured by the ICE BofAML US High Yield Master II Index, stood at 3.45%, close to the prerecession low of 3.24% seen on Jan. 26.
This dislocation of the previously tight correlations between equity volatility and high-yield credit spreads is pushing investors to the conclusion that the asset pair may have decoupled. In the chart below, implied volatility for the MSCI World Index, which tracks large- and midcap equity performance across 23 developed markets, appears to have broken away from junk debt spreads this year, after tracking each other closely in the last two decades.
Some market participants blame loose monetary policy for undermining credit spreads as a useful barometer for the end of the economic cycle. Negative to low interest rates have pushed yield-hungry investors out of government bonds into corporate debt, tightening high-yield bond spreads, which are “potentially polluted as a signalling device,” said Andrew Lapthorne, head of quantitative equity research at Société Générale.
Max Gokhman, head of asset allocation at Pacific Life Fund Advisor, said an expected flood of Treasury issuance amid a ballooning government deficit, derived primarily from corporate tax cuts signed into law late last year by President Donald Trump, the Federal Reserve’s efforts to unwind its more than $4 trillion, crisis-era balance sheet, can be troubling for markets. “It doesn’t paint a great picture,” he said.
But the muted reaction in high-yield spreads could simply reflect confidence the economic expansion has further to run, keeping default rates low. S&P Global Ratings expects the high-yield default rate to fall to 2.6% in Dec. 2018, compared with 3% in Dec. 2017 and 5.1% in Dec. 2016.
“I don’t really get the sense [late-cycle fears] are reflected in the positioning so much. You can judge that pretty well because in a year that has had as much volatility as 2018 already has had, you’re not seeing much in the way of the credit markets widening or increasing risk premiums,” said Tad Rivelle, chief investment officer at TCW Investment Group, in an interview with Bloomberg TV.
All that said, some still see corporate credit spreads as a useful bellwether, but argue that investors are paying attention to the wrong benchmark.
“It still works, at least for investment-grade. They’re telling us that we’re heading into the late-cycle” said Jody Lurie, a corporate credit analyst for Janney Montgomery Scott. She said increased access to the junk-bond market with the advent of high-yield bond exchange-traded funds may have skewed its reliability as a late-cycle indicator.
The spread for the ICE BofAML US Corporate Master index, a benchmark for U.S. investment-grade paper, widened to 1.15%, from a prerecession low of 0.90% in February. As a result, investment-grade debt posted a negative return of 2.2% between January to March, its worst performance since 2008 for any such period.
But if, and when, high-yield spreads do blow out, equity investors should watch out, said Gokhman. Ownership of the junk-bond market remains concentrated in a few long-term institutional investors.
So, when even these veterans don’t want to keep high-yield debt on their books, it should raise deep questions over the ability of U.S. firms to pay their creditors.
Read: Here’s why default rates are subdued even as corporate debt levels hit records