While it’s true that current credit spread levels are uncommonly low for the post-financial crisis era, they are actually at levels that are quite common when compared to other periods of U.S. economic expansion and low corporate default rates.
Credit investors receive spread compensation for the risk of default losses. Credit default rates have declined meaningfully during the past six months and, with the passing of the commodity crisis, investors currently expect future default rates to remain low. Expectations for meaningfully lower default rates warrant a significant drop in spread compensation. However, this decline in default-loss compensation accounts for some but not all of the recent decline in corporate spreads.
What else is contributing to lower spreads? Credit investors also receive compensation for other risk factors, including illiquidity, volatility, and uncertainty. For simplicity, the compensation for these other risk factors can be thought of as an “uncertainty premium.” And this uncertainty premium has been a large contributor to the recent decline in spreads.
The uncertainty premium tends to be pro-cyclical. Weaker economic growth and higher default rates translate into a higher uncertainty premium, and vice versa. Following the financial crisis, the uncertainty premium steadily declined as the economic environment improved and became more stable. However, the recent commodity crisis had a negative impact on a broad array of corporate issuers and a number of global economies, which led to a setback in this downward trend for the uncertainty premium. Commodity prices have largely stabilized and with this crisis seemingly in the rearview mirror, the uncertainty premium has begun to recede once again. As a result, credit spreads are near the post-financial crisis low point.
Yet history suggests that spreads at this level are not necessarily overvalued. This is particularly true within the context of a tame outlook for default rates and a constructive view regarding economic growth.
Let’s take a closer look. In assessing the value of the credit markets, investors need to assess the probability and consequences of a change in the landscape that moves the environment to a less favorable and more uncertain state, i.e. a spike in the “uncertainty premium.”
In our Investment Themes for the first half of 2017, we shared our expectations for modest default rates and supportive economic growth over the next several quarters, which means our outlook supports credit spreads at these low levels. That said, we are closely monitoring developments related to U.S. economic policy and European elections, which we believe are the most likely near-term catalysts for increased market uncertainty and potentially higher spread levels.
The charts below plot the daily spread history for the high-yield market from 1994 to the end of February 2017. Orange dots represent the full history while gray dots show the spread history during economic and market environments that are “similar” to today. In the context of our macro credit research, how we define “similar” is a critical component of our approach to assessing relative value. In this particular case, “similar” is defined by:
- ISM manufacturing new orders at or above 50
- Trailing 12-month high-yield default rate below 5%
- U.S. manufacturing and trade sales growth at or above 0%
- Volatility (as measured by the VIX index) below 25
So how should investors in multi-sector fixed income strategies think about portfolio positioning in the current environment? From a short-term tactical perspective, we viewed the spread tightening in the first quarter of 2017 as an opportunity to reduce risk and provide flexibility to take advantage of potential market volatility. From a longer-term strategic perspective, as long as our investment theses for healthy economic growth and low default rates remain in place, we see any credit market weakness as a buying opportunity for investors who are underexposed to credit risk.
Environments Marked by Economic Growth and Low Default Rates Have Historically Created a Tight Range for Credit Spreads
Source: Voya Investment Management, Bloomberg and J.P. Morgan. Data is from the period 1/31/1994 through 2/28/2017. “Similar conditions” defined as 1) ISM manufacturing new orders at or above 50; 2) Trailing 12-month high-yield default rate below 5%; 3) U.S. manufacturing and trade sales growth at or above 0%; and 4) Volatility (as measured by the VIX index) below 25.
Past performance does not guarantee future results.
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