Uncommon truths: Are credit spreads wide enough?

Looking at historical data in US credit markets to determine if spreads are wide enough today.
Uncommon truths: Are credit spreads wide enough?

Have credit spreads widened enough?  We think the answer depends upon what happens to the economy and we use US credit markets to give historical context.  This leaves us more concerned about high-yield than investment-grade but we believe spreads could still widen in both. 

As is often the case during recessions, credit markets have received a lot of attention.  Spreads have widened and liquidity has been difficult at times (according to my trader colleagues).  So, how bad has it become and what does the credit market tell us about the state of the economy? 

In what follows, we focus on US credit markets but we were able to take a broader look in the recently published Big Picture document.  Considering a range of possible economic scenarios, we found that investment-grade credit (IG) was favoured by our optimisation process in all cases.  High-yield credit (HY), on the other hand, was only favoured in the milder economic scenarios. 

Focusing on US credit markets, Figure 1 shows not only the extent of the widening in the IG spread but also the rapidity of that widening.  It is hard to find any comparable widening since 1919 that occurred so abruptly (we use Moody’s Aaa and Baa yields as a proxy for IG yields in those earlier periods).  Historically, such widening has been a gradual process, not a vertical ascent.  The widening of spreads usually suggests problems for the corporate sector, as it not only implies that funding has become more expensive just when it is needed the most and usually signals the drying up of funds.   

Unfortunately, the US corporate sector entered this recession with a lot of debt (BIS data suggests that non-financial sector corporate debt was 75% of GDP in 2019 Q3, a record).  Such a debt burden is no problem when rates are low and the economy is doing well but becomes an Achille’s heel under current circumstances.  US businesses will need to cut back on a lot of expenditure, including dividends and share buybacks, in our opinion. 

The only time the IG spread was wider was during the Global Financial Crisis (GFC).  Interestingly, during times of stress, the IG spread detaches from that of Aaa bonds and resembles more that of the Baa segment.  That Baa spread has only been noticeably higher during the GFC and the Great Depression.  On that basis, it would appear the IG market has priced-in a “normal” recession but not something of the nature of the Great Depression nor the GFC. 

As a reminder, during the Great Depression US industrial production declined by 54% (from top to bottom) and GDP declined in 1930 (-8.6%), 1931 (-6.4%), 1932 (-13.0%) and 1933 (-1.3%).  By comparison, the GFC was a mild recession, with US industrial production and GDP falling by 17% and 4%, respectively (from top to bottom).  GDP fell by 0.1% in 2008 and 2.5% in 2009. 

Figure 1

Of the four scenarios we considered in The Big Picture, the very worst-case implied a 3.5% drop in global GDP in 2020, which is consistent with a 4.5% decline in US GDP.  That sounds roughly equivalent to the top-to-bottom drop during the GFC but this is likely to be a very different situation.   

In fact, that very worst-case scenario implies a top-to-bottom drop in global GDP of 20%-25% in the space of two quarters.  That sounds more like the Great Depression than the GFC.  However, we also assume a rapid rebound during 2020 H2, hence the full year GDP decline being limited to 3.5%.  Without the intervention of policy makers, we suspect the impact on credit spreads would be somewhere between what happened during the GFC and the Great Depression.  In that case, we would expect a further widening of IG spreads and investment losses. 

However, policy makers have intervened in two important ways: first, governments and central banks are trying to protect the cash flows of households and businesses, thus cushioning the economic decline.  Second, many central banks have launched asset purchases programmes and an increasing number now include corporate debt.  Taken together, these actions should limit the drop in GDP and the widening of spreads.  Consequently, the worst we can imagine is a widening of spreads to GFC levels.  That would be painful for IG investors but we believe that other asset classes would fare even worse under such a scenario (equities, real estate and commodities, say). 

We include US HY in the list of assets we would want to avoid under that worst-case outcome.  Figure 2 shows the relationship between the US HY spreadand the economic cycle (as expressed by growth in industrial production).  Unsurprisingly, spreads widen during economic downturns.  More surprising is that US HY spreads had not already reacted to the deceleration in US industrial production evident since late 2018.  In our opinion this was the credit market counterpart of the US equities hitting all-time highs as profits decelerated.  With hindsight, financial markets were in a state of suspended animation (or perhaps delusion). 

Two things suggest to us there is a risk of HY spreads widening further: first, the Covid-19 inspired decline in industrial production hasn’t even started to show in Figure 2 and there is a risk spreads could widen again when it does.  Second, those spreads have not even reached normal recession levels, never mind what was seen during the GFC.  Indeed, another ten percentage points of spread widening would be needed to reach GFC proportions.  Add on top of that a default rate of 16% (as reported by BAML at the time of the GFC) and it is not hard to imagine a 30% one-year loss on US HY (the result under our very worst-case scenario). 

That may be overly bearish but it does highlight the downside risk to HY under the worst economic scenarios.  Unsurprisingly, our optimisation process found no place for HY in the worst-case scenarios, though it did suggest that we adopt maximum exposure to IG under all scenarios (even with a projected loss for US IG of 11% in the very worst-case).  IG seems to offer a good combination of risk, reward and diversification.   

Figure 2
Source: ICE BofAML. data as at 17 December 2019.

Unless stated otherwise, all data as of 3 April 2020. Paul Jackson is Global Head of Asset Allocation Research with the Global Market Strategy Office. András Vig is Multi-Asset Strategist with the Global Market Strategy Office.