HY-IG Spread Compression

We look at where the 2023 YTD rally leaves IG spreads and the HY-IG differentials in historical context.

In this note, we update the timeline from 1997 through current trading levels for context. As of last night close, the IG OAS at +120 bps is now trading through the long-term median of +134 bps. That +120 bps is still materially wide to the bull market median of the pre-crisis period when the UST curve was more normalized in the pre-ZIRP. In a separate chart below, we also look at the HY-IG OAS differentials as the HY market is putting together a major rally as the risk-chasing trade is on YTD in both equities and credit.

In our weekly commentary, we looked at the comparison of the 4Q18 HY sell-off and strong 2019 rally as a frame of reference (see Footnotes and Flashbacks: Week Ending Feb 3, 2023). The swing was much more intense in HY and down in the CCC tier, but the IG index also took some pain in late 2018 swinging from the low +100 bps range in early Oct 2018 out to approximately +160 bps by year end. Then the 2019 rally kicked into gear back to the low 100s by year end before the early 2020 COVID crisis.  As a reminder, there was no shortage of cyclical debates back in 2019 as the Fed cut three times and growth was stalling. 

The chart above follows the OAS path from the lows of 1997 across the TMT bubble, the housing sector boom and bust, and then the systemic crisis that hammered so many IG-rated banks and brokers and blew up a few major insurance players. Then came the longest expansion in history that COVID brought crashing down. We highlight the long-term median in the boxes along with some key timeline medians.

The IG OAS trend line above starts back with the 1997 low tick of +53 bps in early October. That was before the Asian crisis ramped up with a vengeance on the way to a volatile 1998 with EM contagion fears by summer and the infamous LTCM counterparty crisis that pulled the Fed briefly into cutting mode during the fall. 

For the median subsets, we would highlight that the median IG OAS for 1997 to the March 2001 cyclical peak stood at +114 bps, modestly below last night’s IG index close. The start of the next expansion in late 2001 through the Dec 2007 cyclical peak posted a +98 bps median, which is also below where the IG market is now.

The post-crisis IG OAS math got trickier after the Fed crisis support (ZIRP and QE) with the UST curve so low some incremental spread would be needed to bolster (however slightly) the all-in yields. We see a +147 bps median from the start of the longest expansion in the modern era from July 2009 to Feb 2020. We are now comfortably through that median at +120 bps as the yield curve has risen materially.

The UST curve shift higher offered fresh incentives to those looking to balance portfolios into bonds at the new levels. The UST migration has padded the all-in yields at steeply discounted dollar prices (and coupons) in IG after so much refinancing since the credit crisis and through the COVID support periods that sent the Fed back to ZIRP mode.

Back to the 2018-2019 comparison…

We have covered the histories before in numerous commentaries in the article archive, but the reminders of the highs and lows offer an excuse to compare material events. Each cycle had some dramatic moments in market history. The late 2018 sell-off into a very strong 2019 risk rally offers an exercise in past vs. prologue, and so does the late 2011 spread wave as sovereign pressures and systemic debt came to a head. The current debt ceiling threat and heightened brinkmanship offers some stark reminders of that period with partisan hatred rising among more extreme elements in Washington. The heat is higher in Congress now than in 2011 – without question.

During 2011, Europe had systemic stress in the air, and now in 2023 they have the largest land war in Europe since 1945.  Europe was the bigger worry since Russia moved in and Europe faced recession. Some would argue the US political turmoil is the bigger risk in 2023. That would be self-inflicted for the US, but Russia is not going anywhere anytime soon. 

The above chart plots the HY – IG OAS differentials over the same time frame as the earlier chart. Risk-on markets and favorable flows bring on quality spread compression as seen in the chart.  The quality spread tightening for IG vs. HY has been underway with a vengeance. The differential is down to +279 bps at 2-7-23 from +339 bps in early Nov 2022.

The trends have been supportive after such a steep sell-off and materially negative returns in equities and credit and duration broadly during 2022. The trajectory for inflation is down and unemployment hit a new 50 year low. That is a tough balancing act among numerous economic indicators.

If you believe that fundamentals, earnings, or credit quality overall will not see pressure in the year ahead or that proportionate risk premiums will not need to adjust, then there is a story to tell here on how it can hold up (the 2019 scenario). That is not our scenario as fundamentals are still decidedly mixed and some of the outlying events are going to weigh on risk appetites as the debt ceiling insanity plays out. China and Russia are ripe for more tension with the US.

We can compare to any period for the exercise, but 2019 with its great risk performance is a recent example coming off a bad year in 2018. The Fed was easing in 2019 but tightening in 2023.  Inflation was not an overhang in 2019, but there is still meaningful inflation now. The consumer held in during 2019 (PCE was positive all four quarters in 2019) and the consumer still looks good for 2023.

Fixed asset investment held up well enough in 2019 (structures, equipment, residential), but housing is getting slammed right now and equipment and structures are vulnerable. The geopolitical backdrop is flat out bad in 2023 with China and Russia. We will need to watch the moving parts closely (trade tension, supply chains, commodities inflation, etc.). In 2019, Trump tariffs had the US at odds with trade partners and that slowed investment in some major sectors.

The scales will keep weighing these variables in 2023. Right now, the early year rally is on.