- In times of uncertainty or deteriorating economic conditions, US Treasuries and credit spreads typically move in opposite directions, with Treasury yields rising and spreads widening. Should investors be concerned about this dynamic today?
- Inflationary pressures, a more aggressive Federal Reserve and conflict in Eastern Europe may be contributing to — even exacerbating — the current credit spread environment.
- Given the general health of US corporate balance sheets, it’s likely (although nothing is certain) that widening spreads are being influenced by a confluence of external factors and not necessarily predicting near-term economic hardship. However, vigilance is required in monitoring spreads.
Economic Vista: studying the spread
Jose Sevilla, Senior Portfolio Manager
Investors have been known to use credit spreads — loosely defined as the difference between Treasuries and another debt security of similar maturity — as a tool to gauge where the economy is going and, by extension, how to best allocate fresh capital. So, let’s look at what widening spreads have meant in the past and consider what today’s spread may be signaling.
A look back
In times of uncertainty or when economic conditions are expected to deteriorate, US Treasuries and credit spreads typically move in opposite directions. Such a dynamic has played out in some of the more challenging, event-driven periods over the past two decades, including the Enron scandal in 2002, the Global Financial Crisis in 2008–2009, the Greek sovereign debt crisis in 2011, the collapse of oil prices in 2016 and most recently the pandemic in 2020. In each instance US Treasuries rallied while credit spreads widened. The accompanying chart illustrates this.
Gray bands indicate periods of time where credit spreads widened.
Source: Bloomberg, ICE Indices — IG Corp (ICE BofA 1–10 yr. US Corp Index), US Treasury (ICE BofA 1–10 yr. US Treasury Index).
This year we have, once again, seen US Treasury yields move dramatically higher while credit spreads have widened. Thus, if credit spreads are the extra yield that investors get paid for taking on the perceived risk of default, is this a leading indicator that problems may be surfacing in the financial markets? Perhaps it’s too early to come to that dire conclusion.
We believe that one of the factors behind widening credit spreads this year is the expectation that the Federal Reserve will aggressively hike rates and tighten financial conditions. Companies are facing higher borrowing costs, which may impede their ability to raise capital for expenditures, fund new acquisitions, or even service or refinance existing debt. For evidence, we see new issue corporate bond deals have been pricing wider and with higher concessions, thus repricing secondary issues cheaper.
One of the main motivators behind tightening monetary conditions is the Fed’s commitment to control inflation. We’ve witnessed inflation continue to rise steadily since November 2020, due to a combination of pent-up consumer demand in the wake of the economy reopening, generous amounts of economic stimulus and historically low rates. Meanwhile, lingering supply chain bottlenecks, rising energy and shipping costs, shortages of goods and average wage increases have stoked inflationary pressures. The February Consumer Price Index (CPI) report exhibited a 7.9% increase in consumer prices compared to the previous year. That is the biggest jump in consumer prices in the last 40 years (January 1982).
In response, the Fed recently raised the fed funds rate by 25 basis points (bps) at the March 16 Federal Open Market Committee (FOMC) meeting, with the market projecting that the Fed will increase the fed funds rate eight or more times this year. While the Fed is clearly committed to taming inflation, there is always the risk that the Fed could tighten too aggressively and cause the economy to fall into a recession and potentially prompt a sell-off in credit markets.
Sources: Bloomberg, based on Overnight Index Swaps (OIS) curve. Data as of 3/21/2022.
The geopolitical wild card
As is often the case, major geopolitical events tend to complicate the credit spread message. Russia’s invasion of Ukraine triggered sweeping economic sanctions and a concerted reaction from many global corporations, causing approximately 200 companies to abruptly cut ties with Russia. Simultaneously, we have witnessed a significant spike in energy, commodity and food prices. The armed conflict in Eastern Europe has ushered in a period of elevated volatility with risk-averse investors looking for safe havens. Is it any surprise that credit spreads widened during the first quarter?
With all these moving parts — rising inflation, higher interest and heightened geopolitical tensions — investors are wondering if wider credit spreads are truly signaling growing default risk, or whether recent volatility is exaggerating this potential. Late in the first quarter, credit spreads began to retrace as investors seemed to be slowly moving off the sidelines, though the situation remains fluid. New issue corporates were pricing tighter and at lower concessions over the last two weeks in March. Fed Chairman Powell also reiterated his belief that the US economy can withstand multiple rate hikes since the macro backdrop remains solid.
There are other reasons for optimism. For example, we see solid fundamentals for many US companies, with strong balance sheets, record cash balances and continuing earnings growth. Interest coverage ratios remain above average, while overall corporate default rates are at historical lows. Based on these factors, there is a strong likelihood that widening credit spreads are indeed overestimating the credit risks.
Nevertheless, uncertainty remains high. Thus, we continue to pay heed to the credit spread message if a new low-growth, high-inflationary environment emerges. And given the Fed’s hawkish tone and the likelihood that interest rate volatility will continue, we recommend maintaining a disciplined approach to credit selection, focusing on higher quality and strong fundamentals to mitigate portfolio volatility.
Credit Vista: coming out strong
Nick Cisneros, Credit Research Associate
Over the past two years, investors have faced no shortage of bad news — rising inflation, supply chain disruptions and soaring commodity prices, to name a few. So what exactly have these negative headlines meant for the overall quality of investment-grade corporate credit issuers? Not much! Investment-grade corporate credit has been resilient in the face of it all.
Source: Moody’s Annual Default Study.
For example, take industrial issuers who currently benefit from very constructive credit conditions. While the pandemic has complicated the ability to forecast, industrial issuers have still been able to strengthen their credit fundamentals. The following chart shows an index of SVB Asset Management’s (SAM’s) approved industrial issuers. Free cash flow has hit the highest level in the past five years, while leverage ratios have trended lower. Industrial issuers have returned to pre-pandemic leverage levels with even more excess cash flow. We do note that while dividend growth and share buybacks were paused during the height of the pandemic, we have seen an uptick in those areas and expect them to be a priority this year as issuers are flush with cash. Liquidity has improved across our industrial issuer base as many have taken advantage of the low-rate environment and strong earnings before interest, taxes, depreciation and amortization (EBITDA) to issue longer-term notes cheaply and without tacking on significant leverage.
Source: SVB Asset Management, Bloomberg.
Similarly, financial issuers have also been able to navigate the challenging headwinds and have emerged with capital ratios moving above pre-pandemic levels. Bank asset quality remained sound during the past two years with charge-offs across the sector far below the pessimistic predictions of March 2020. Expansionary monetary policy allowed both enterprise and retail customers to improve their respective balance sheets and minimize such write-offs. Capital levels have risen well above pre-pandemic levels on the back of strong earnings, as illustrated by the following chart of SAM’s approved financial issuers. We expect these capital levels will not rise much further as banks begin to prioritize both shareholder returns and, likely, new M&A activity. But even as these shareholder return programs and potential M&A begin to gain traction later this year, we feel financials are well positioned to maintain a stable credit profile.
Source: SVB Asset Management, Bloomberg.
While it is possible that today’s rosy credit conditions may deteriorate slightly in 2022, the overall credit profile across our issuer base remains extremely strong. If contractionary monetary policy fulfills its intended goal of cooling down inflation (and by extension also slowing economic growth slightly), we still have high conviction in our issuer base. These companies have been vetted and have strong balance sheets and positive earnings outlooks. Moody’s does forecast a slight uptick in default rates for 2022, but even those numbers are below historical averages. Thus, even if the economy cools and the headlines remain worrisome, the overall health of investment-grade credits looks good.
Trading Vista: changing expectations
Jason Graveley, Senior Manager, Fixed-Income Trading
Although many investors have been focused on Ukraine and Russia during the first quarter, it is quite likely that more mundane issues closer to home might have been responsible for some of the swings in fixed-income markets during March. Performance across credit benchmarks was volatile throughout the month, and once again investors can look to the Fed to understand why. While there is uncertainty surrounding the path and magnitude of this rate-hike cycle, the repricing of Fed expectations has been sharp to say the least.
Markets have transitioned from pricing in two rate hikes for all of 2022, to a decidedly more aggressive eight or more rate hikes at the time of this writing. This shift has created headwinds and resulted in negative total returns for most indices. Various Fed speakers have vocalized the possibility of more aggressive policy maneuvering to quell inflation, even raising the potential for 50 bps hikes at the May and June FOMC meetings. This negative performance has, unsurprisingly, resulted in a flight from front-end funds. By some estimates there have been nearly $27 billion of outflows across investment-grade, fixed-income mutual funds and exchange-traded funds (ETFs) year-to-date (YTD). So where has all this cash settled?
Despite the outflow from corporate bond fund complexes and the corresponding widening in credit spreads, there is no shortage of liquidity in markets. The Fed’s Reverse Repo facility and overall money market fund (MMF) balances continue to grow, extending trends that have been in place for most of the past year. For this past March, the Fed’s Reverse Repo facility printed its yearly high, with more than $1.87 trillion sitting idle in the program. If we dive further into the growth of MMFs, the dichotomy between pre-COVID-19 assets under management (AUM) and today is drastic. In total, MMF AUM have grown by more than $1.1 trillion over the last two years, which is roughly 25%. On a more individual level, Morgan Stanley’s fund complex has grown from $134 billion to more than $300 billion over the same period.
It remains to be seen how much of this cash will be deployed as yield curve and rate expectations evolve. Although the longer end of the curve remains flat and inverted at points, there remains substantial basis between different front-end maturities. The curve peaks at roughly three years, although much of the steepness is evident between the 3-month and 2-year Treasury — points where our investments are concentrated. There are almost 190 bps of steepening priced into these parts of the curve, which suggests that current purchase yields should be well supported even in a relatively hawkish hike cycle. As always, we remain ready to pivot as rate expectations and money flows continue to evolve.
|Treasury Rates:||Total Returns:|
|3-Month||0.48%||ICE BofA 3-Month Treasury||0.03%|
|6-Month||1.01%||ICE BofA 6-Month Treasury||-0.04%|
|1-Year||1.60%||ICE BofA 12-Month Treasury||-0.38%|
Source: Bloomberg, Silicon Valley Bank as of 3/31/2022.