A credit spread is simply the difference in yield between a bond and a US Treasury of the same maturity. Supportive fundamental and technical factors have steadily narrowed credit spreads in US investment grade, high yield and emerging markets since early 2016. A bond’s credit spread typically narrows as an issuer’s credit quality improves or investor demand pushes its price higher. Figure 1 shows that US high yield spreads, for example, have dipped well below their long-term average in recent months likely due to positive US growth prospects and strong investor demand.
Although US high yield — and credit in general — is currently trading rich, history shows that markets can stay rich for long stretches of time. This is illustrated in Figure 1 by the periods from 1993 to 1998 and 2004 to 2007. The level of spread compression during these periods was even more pronounced than the amount seen in recent years.
What is driving credit valuations?
We believe a combination of macro factors has driven US credit spreads tighter. These include robust growth, benign inflation and accommodative monetary policy. We have found a strong relationship between asset class performance and different economic regimes. Our “macro-factor framework” suggests that credit spreads tend to perform well when the economy is growing, inflation is stable and financial conditions are easy. This is precisely the situation we find ourselves in now (Figure 2).
While the Federal Reserve (Fed) has embarked on policy tightening and has announced plans to begin balance sheet tapering this fall, it has maintained a gradual approach with the aim of avoiding market disruption. Inflation has been lower than expected (allowing the Fed this flexibility) while US growth has remained strong. This combination of steady growth, persistently low inflation and easy monetary policy has supported US credit assets, in our view.
Outside the US, a similar economic regime of moderate growth, low inflation and easy monetary policy has been a tailwind for US credit. Aggressive Japanese and European central bank stimulus, upside growth surprises and below-target inflation in both regions have fueled foreign purchases of US corporate bonds amid a global hunt for yield.
Outlook and risks
Will this benign backdrop for US credit continue? Our macro models indicate that US and global growth are likely to remain solid and global inflation is likely to remain stable. Most central banks are also expected to keep monetary policy relatively accommodative (despite pivoting away from emergency stimulus) as inflation stays subdued. This points to a generally supportive environment for US credit, in our view.
In the US, the lack of upside inflation pressure could cause the Fed to delay additional interest rate hikes, which could further support credit. However, our models suggest that inflation is likely to stabilize in the next few months, keeping the Fed on track to raise interest rates again later this year or in 2018. In either case, Invesco Fixed Income’s credit analysis suggests that credit markets would likely absorb gradual monetary tightening.
Risks to our forecast
The main risks to our view center around an unexpected sharp increase in inflation that could cause global central banks to accelerate their pace of tightening. The removal of labor market slack that finally manifests in wage pressures or a supply/demand shock could be the source of an inflation surprise. A more aggressive policy cycle does not appear to be priced into bond markets and could be disruptive to credit assets. Although not our base case, we believe this risk is worth monitoring.
Option-adjusted spread (OAS) is the yield spread which must be added to a benchmark yield curve to discount a security’s payments to match its market price, using a dynamic pricing model that accounts for embedded options.
Standard deviation measures a portfolio’s or index’s range of total returns in comparison to the mean.
Valuation is how the market measures the worth of a company or investment.
Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer’s credit rating.
The iShares iBoxx $ High Yield Corporate Bond ETF (HYG) was unchanged in premarket trading Wednesday. Year-to-date, HYG has gained 5.37%, versus a 15.35% rise in the benchmark S&P 500 index during the same period.
This article is brought to you courtesy of Invesco.