HY Spreads: Celebrating Tumultuous Times at a Credit Peak

We update HY spreads coming off jobs, CPI, and an FOMC on hold with HY spread levels below the 2014 and 2018 lows and closing in on 2021.

Jun 13, 2024

It’s not the years, it’s the cycles…

We look back across the decades and frame the context of the latest HY spread rally this week into the low 300s.
Current HY spreads are below 2014 and 2018 lows and creeping closer to 2021 lows even if still a long walk from the Oct 1997 and June 2007 lows.
We recap some earlier lows as a useful memory jogger and mixed staying power of spread lows in what followed.
We update the HY vs. IG quality spread differentials for the latest rally.

The chart above updates the timeline for HY OAS across the period from 1997 credit market peak. The 1997 lows came at a time when the credit cycle had some room to run until HY default rates crept up to near the 6% threshold in late 1999. That was before the “TMT cycle” went into a 3 year crash and double dip default wave that ran well beyond the TMT world (think Enron). We have addressed those periods in past commentaries (see links at bottom). We use this commentary as a memory jogger on past HY lows and to give current pricing levels some historical context.

We also update the quality spread differentials for the spread increase and credit compensation for the move from IG bonds into HY bonds.

A quick lookback across time…

The 1997 credit cycle peak and spread lows: The HY market hit spread lows in Oct 1997 at +244 bps. The year 1997 ended at +296 bps. Life stayed bullish on risk alongside a strong economy until the world of EM (Russia default Aug 1998) and leveraged positions in the system (LTCM and Lehman rumors) in the fall of 1998 saw HY OAS move from +300 bps handles in early Aug 1998 to +678 bps in mid-October 1998 (Note: We source this data from the Fed, YCharts, and ICE). The Fed got busy easing to take the heat off and pressured the banks/brokers to orchestrate an LTCM bailout (note: Bear Stearns said “no” and Lehman could only afford a much smaller slice than the others in an ominous sign of what happened a decade later).
The 2007 credit bubble: The low level of HY OAS was hit twice in early June at +241 bps, but the moving parts were moving quickly with June 2007 ending at +298 bps and the year 2007 ending at +592 for a +351 bps move off the lows. It was all downhill from Dec 2007, which was later tagged as the start of the recession by NBER as 2008 saw Bear collapse in March ahead of the conflagration of Sept 2008 (Lehman, AIG, BofA/Merrill merger, etc.) HY market makers were disappearing left and right and the fate of secondary market depth followed.
The June 2014 credit cycle mini-peak: The risk appetites rolled into the 2014 spread tightening wave after the best year for the S&P 500 since the crisis (+32.5%) was booked in 2013. That solid year in 2013 came despite the taper tantrum whipsaw on the steepening of the UST curve and ensuing duration pain that hit IG and UST. HY spreads hit +335 bps on 6-23-14 ahead of a summer that saw oil prices in triple digits before the Saudis went to the 1986 playbook and started a price war to bleed the US E&P sector into submission and perhaps deter lending and debt-funded capex aggression in the US (or anywhere else). That sent HY spreads to +504 bps by 12-31-14 (+169 bps wider than the June lows) as the largest HY sector (Energy) was pounded and the repricing of quality spreads spilled over to investment alternatives.
The 2018 rally to 4Q18 lows and rapid spread spike: The 2018 market remains one of the harder markets to explain given how quickly HY spreads unraveled in 4Q18. The HY spread lows came on 10-3-18 at +316 bps. Oil hit a post-2014 high just before the meltdown started but HY widened in 4Q18 to +533 bps by year end or by +217 bps. Oil prices tanked again to wind down the year. The CCC tier was especially crushed in Dec 2018. The 2018-2019 relative asset performance saw 2018 as a terrible one for the top performers with cash at #1 in the broader asset class mix vs. bonds and equity benchmarks (see Histories: Asset Return Journey from 2016 to 2023 1-21-24).
The post-COVID 2021 lows: The market saw a monster rally in the world of ZIRP and the best year for economic growth since the Reagan years (see US Debt % GDP: Raiders of the Lost Treasury 5-29-23). Fiscal stimulus came in waves in late 2020 and early 2021. HY OAS hit numerous lows in 2021 slightly below the +309 bps close of last night (6-12-24) from the summer of 2021 on through late Dec 2021 with +301 bps on 12-28-21 after hitting +302 bps in early July 2021. The year 2021 posted many records, but the spread lows did not get back to the levels seen in June 2007 or Oct 1997. The +301 bps low was close to the +296 bps that closed out 1997 and the +298 bps at the end of June 2007.
The tightening cycle and “mornings after”: The widening of spreads after the 2021 credit cycle peaks has sustained some wide spreads since then as HY OAS moved above the +400 bps line in May 2022 before bouncing around and crashing the +500 bps line in June 2022. The market saw intermittent rallies and widenings during 2022 including +599 bps in early July, then a rally, then back above +500 to end Aug before ending 2022 at +481 bps. That leaves a lot of room to swing around from here.

As we look where we go from here, the market is at least likely to see 1 cut from the FOMC this year (see FOMC: There Can Be Only One 6-12-24, May CPI: I Feel Good, Not Sure That I Should 6-12-24). It takes a lot to set off upward credit spread spirals, but fundamentals seem to have less of a fuse in this market than the macro top-down risks we often discuss in trade and domestic instability. The items on the checklist are in the eye of the beholder, but they include mass deportations, social unrest, deployment of military on domestic soil, and political risk generally around budgets and debt ceilings (see Trade Flows: More Clarity Needed to Handicap Major Trade Risks 6-12-24).

We cannot control the needs or the interests of global lenders (China? Japan?) for such a mass global borrower (the US). Lower rates in a recession might make the UST and the currency less attractive to some even if it offers some relief on the record interest bill. That can then have the opposite effect on what clears the market with record supply.

The consumer sector is eroding slowly on too much credit card debt but the consumer debt systemic profile overall is not like the pre-crisis period by any stretch (see Systemic Corporate and Consumer Debt Metrics: Z.1 Update 4-22-24). It is very hard to have a recession without negative PCE (see 1Q24 GDP: Second Estimate, Moving Parts 5-30-24).

The mix of factors in the economy (jobs, wages, consumer demand, fixed investment trends, sustained homebuilding cycle despite higher mortgages, low mortgages locked in for sustained household cash flow savings, high home equity cushion, etc.) have supported constructive views on the resilience of the credit cycle.

The laundry list of risks that we look at routinely from the unpredictable geopolitical wildcards (Ukraine war zone and border risks with NATO, Taiwan, Iran, trade war escalation, etc.) are just that – unpredictable. The sector level (construction, homebuilding and housing, autos, cap goods, retail, tech, etc.) have not set off alarms yet on fundamental weakness and have more often generated worries of strength and FOMC higher for longer. That said, the aerospace chain is getting choppy with Boeing issues and tension with China.

Earnings guidance is solid, the economy is more diverse than ever, banks have some mixed spots (real estate and regionals), but the bulk of the financial services community is solid. There is less domino credit risk and leverage in the system after Dodd-Frank and some “behavioral shifts” at the banks in risk taking.

The rise of private credit asset gathering and expected growth in that market also eases the risk of credit contraction in the corporate sector even if it is easy to speculate on bad outcomes in underwriting and loan quality as well as the reliability of the marks (“one man’s low volatility is another man’s mismark”, “volatility washing” etc.) That all adds up to a credit cycle that brings a world of difference from 2000 to 2002, when CCC tier sat on the bottom of the excess return list for 3 straight years across what ended up as the longest default cycle in history.

There are certainly a lot of moving parts that can balance each other out when some work out and some don’t. The mega macro risks are the ones that can dwarf the other variables if risk aversion kicks in a response to geopolitics or extreme domestic craziness.

Contributors:

Glenn Reynolds, CFA glenn@macro4micro.com

Kevin Chun, CFA kevin@macro4micro.com

Systemic Corporate and Consumer Debt Metrics: Z.1 Update 4-22-24

Credit Markets Across the Decades 4-8-24

Credit Cycles: Historical Lightning Round 4-8-24

HY vs. IG: Quality Spread Differentials and Comparative Returns 2-6-24

BBB vs. BB: Revisiting the Speculative Grade Divide Differentials 2-5-24

Histories: Asset Return Journey from 2016 to 2023 1-21-24

HY vs. IG Excess and Total Returns Across Cycles: The UST Kicker 12-11-23

US Debt % GDP: Raiders of the Lost Treasury 5-29-23

Wild Transition Year: The Chaos of 2007 11-1-22