Footnotes & Flashbacks: Credit Markets 6-23-24

We introduce “Footnotes and Flashbacks: Credit Markets” to complement our “Asset Returns” and “State of Yields” weeklies.

Jun 24, 2024

Reaching can be risky…

The credit markets had an uneventful week in the markets overall with IG spreads ticking slightly wider and HY tighter with some recent swings in the yield curve distorting some of the HY OAS moves.
Spread compression remains the theme as recently covered in detail (see HY Spreads: Celebrating Tumultuous Times at a Credit Peak 6-11-24, HY Spreads: The BB vs. BBB Spread Compression 6-13-24) even if the quality spreads moved slightly wider since our last recap.
The search for a transmission mechanism to material spread widening is still not readily evident as companies gear up for 2Q24 earnings season and closing the books on another decent quarter.
With another important set of PCE data points and a final read on 1Q24 GDP due this week among the headline releases, we expect the Presidential debate will be just fodder for headlines and a continuation of caustic criticism. That said, it would be nice for voters to know how a trade war and economic turmoil can be avoided given some of the ill-defined policy ideas.

The above chart updates the running IG and HY index yields across the cycles. We see the index yields outside the ZIRP years as the most relevant frame of reference in looking at current credit markets with the pre-crisis median of +6.1% for the IG index and 9.3% HY index yields.

The current 5.42% IG index and 7.86% HY index are a function of lower UST curves in multicycle context outside the ZIRP years (see Footnotes & Flashbacks: State of Yields 6-23-24). We also see very tight spreads more consistent with the 1997 and 2007 credit peaks.

The above chart plots the current IG index yield on the horizontal line set against the IG index yields from two prior peak periods in late 1997 and mid-2007. We also include the UST curves from those periods for frames of reference.

We break out all the historical details on the spreads in prior commentaries (see HY Spreads: The BB vs. BBB Spread Compression 6-13-24, HY Spreads: Celebrating Tumultuous Times at a Credit Peak 6-13-24), and there is little debate around whether current spreads are very compressed now as they were in those markets even if not at the absolute low ticks that we detail in the charts below. The UST curve today is the main driver of the lower all-in IG index yields.

The above chart tells the story of long-term IG index OAS (sources: ICE, Federal Reserve, YCharts). The current IG index OAS of +96 bps is +10 bps to the lows of 2021 but in line with some protracted periods such as the IG OAS averages in 1H04 to 1H07 and across the average of 1997-1998. The early 2005 lows came before the automotive bond exposure got sloppy as that year unfolded and the migration to HY of GM and Ford began in the springtime to the final blows in the summer.

We see the spread spike of the credit crisis in late 2008 as making the other market blowups look mild. The largest sector in IG (banks and brokers) faced the systemic meltdown of meltdowns. The fall 2011 spike was tied to a revisitation of systemic counterparty panic on the back of the Eurozone crisis.

When looking at this chart, it is important to keep the years of ZIRP and minimal rates in mind for how off the charts spreads had to run. The 2011 spread gap was during a ZIRP and QE period as was COVID. For the energy market crisis to the early 2016 OAS mini-peak, ZIRP had just ended in late 2015. After COVID, ZIRP ended in March 2022.

The above chart follows a process we prefer to do for HY where we frame index OAS vs. a relevant benchmark UST (for IG that is the 7Y UST) in order to give some sense of the proportionate risk premium vs. the risk-free asset. We choose a UST maturity that is in the relative zip code of the credit index duration (for HY, we use 5Y UST).

The conclusions are easy enough no matter how you slice the data since spreads (credit risk premiums) are low and spreads extremely tight.

The most relevant periods are those outside the ZIRP backdrop just given the nature of the curve and the “low denominator effect.” That does not nullify the concept since the risk-free asset (the UST) is a logical alternative. They call it “reach-for-yield and take more risk” for a reason in those markets.

If we move outside the ZIRP periods and use the pre-2007 median of 0.23x for IG, that is essentially where the market is today. The full median otherwise would be 0.54x.

The above chart updates the HY-IG OAS differentials across time. This is a useful metric for framing the incremental credit risk compensation for moving into the HY basket from IG. As always, there is an asterisk across such timelines for industry and rating tier mix with the IG index today more BBB heavy than past cycles and the HY index more BB heavy. That would also have the impact of narrowing the spread.

At +225 bps, the “HY minus IG” differential is tight and close to the 2014 credit cycle mini-peak and wide to the HY credit spread lows of Oct 2018. June 2007 and Oct 1997 are dramatically lower. The more recent 2021 tight of +205 bps is inside current levels, but that market was also a ZIRP backdrop.

The above chart plots the BB tier, which for its part has become an alternative for many traditional BBB investors and is not the usual target destination of “HY Classic” mutual fund weightings. The HY Lite strategy has evolved into a very popular allocation for pension funds and wealth managers with the long-term default rates in BBs a fraction of the B tier. Historically, average default rates rise exponentially as you move each time from BB to B and then exponentially again from B to CCC.

As of last week, we see a BB tier OAS of +190 bps, which is well inside the lows of 2022 and just above 2021. The current BB OAS is below the 2018 and 2014 lows but wide to 2007 and much wider than 1997.

The peak BB tier OAS data points are self-explanatory in the chart. During the credit crisis of Dec 2008, the index OAS was facing a high speed trainwreck of spiking spreads, evaporating secondary liquidity, and rating tier constituent migration lags.

The above chart plots the “BB OAS minus BBB OAS” differentials to capture the incremental spread along the speculative grade divide. We use the entire BBB and BB tier even though there can be a big difference between a high BBB vs low BBB and a high BB and low BB. The metric offers some historical context on quality spreads.

The current differential of +72 bps is well inside the long term median of +136 bps. We include some medians for a range of time horizons, and there is no mistaking the current spread differential for anything other than very compressed.

The above chart does the same exercise for HY index yields that we did for IG above. We also include the UST curve from those earlier credit peaks. The current HY index posts lower all-in yields than June 2007 on the yield curve effects and is lower than 1997 for the same reason.

The long-term timeline for HY OAS tells a story of how ugly and how excessively rosy it can get. During 2008, HY bonds became more like high-risk equities with coupons but with massively impaired secondary liquidity. The fact that underwriters and market makers (banks and securities firms) were collapsing, were part of Fed-engineered M&A, subject to regulatory seizure, and even filing Chapter 11 (Lehman) arguably makes the “mark” history somewhat questionable depending on the name, trade volume, and the penalty assigned to a bond.

The more rational “normal” markets in good times are broken out in the chart. The current +321 bps is in line with 2021, 2018, and 2014 lows. Once again, the June 2007 and Oct 1997 lows are more distant. The end of 1997 weighed in at +296 bps while the end of June 2007 was +298 bps, so those periods did materially widen off the lows posted in the chart in a matter of weeks after the lows.

The above chart uses the “HY OAS % 5Y UST” proportionate risk premium approach we cited earlier for the IG index. The HY OAS % 5Y UST to end last week was 0.75x as opposed to the long-term median of 1.96x. The lows in 2018 of 1.05x offer a relevant comparison outside ZIRP even if rates were extremely low in late 2018 (the last hike was in Dec 2018). In other words, today the risk premium is quite low with only the excesses of June 2007 and 1997 lower.

Footnotes & Flashbacks: Asset Returns 6-23-24

Existing Home Sales May 2024: Weary Climb 6-21-24

Housing Starts May 2024: Starts vs. Deliveries Balancing Act 6-20-24

Industrial Production May 2024: Capacity Utilization 6-18-24

Retail Sales: Consumer Fabric Softening? 6-18-24

Consumer Sentiment: Summer Blues or Election Vibecession 6-14-24

Income Taxes for Tariffs: Dollars to Donuts 6-14-24

HY Spreads: The BB vs. BBB Spread Compression 6-13-24

HY Spreads: Celebrating Tumultuous Times at a Credit Peak 6-13-24

FOMC: There Can Be Only One 6-12-24

May 2024 CPI: I Feel Good, Not Sure That I Should 6-12-24

Trade Flows: More Clarity Needed to Handicap Major Trade Risks 6-11-24