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What’s the Buzz – Investment Grade Credit

What’s the Buzz – Investment Grade Credit

May 31, 2024

Recently, we have been hearing “credit is tight” come up in more conversations, both generally and amongst our own team here at BCIS and the financial advisors with whom we partner.  The belief that the credit component of the fixed income market is overvalued (the risk premium or “spread” is lower than it should be, or “tight”) can have a significant impact on fixed income investors as within the investment grade market, credit makes up approximately 25 percent of the market (as measured by the Bloomberg US Aggregate Index).

Starting with a review of spreads, we see that they are near the lows of the post-GFC period (but approximately 8 basis points above their 2/2/18 low of 78):

But what is “spread” and why does it matter? Simply put, the yield difference between a corporate security (in this case) and the “risk free” equivalent (an equivalent US Treasury note), or “spread” is the compensation an investor receives for taking risk.  Spread, therefore, is the risk premium one receives for the risk they take— more risk, more spread, less risk, less spread. This being the case, one cannot simply look at the absolute spread as nothing exists in a vacuum; everything is relative.

The two primary risks (there are many, admittedly) in corporate bonds/credit – as a whole, not speaking to individual company analysis— are duration and default.  The duration of the bond determines its sensitivity to changes in interest rates (as well as indirectly expressing the period of the “unknown”) and default is the risk of not getting repaid.

The duration of the Bloomberg Credit Index (the “Index”) is not static, it varies based upon changes in the profile of the securities within the index. As time-to-maturity and the coupon rate are two be factors in the duration equation, the interest rate environment can be a significant factor in issuance trends.  The chart below shows the change in the duration of the Index:

The duration of the Index is more than one standard deviation below average. As stated earlier, components of the duration calculation are time-to-maturity and the coupon rate.  A closer inspection reveals that when rates are low—say the period from the global financial crisis to the start of the recent restrictive Federal Reserve policy— corporate debt can be issued with lower coupons, and issuers tend to lock in these rates for longer (lower coupon, longer time-to-maturity, higher duration).

As the chart above shows, as rates go down and subsequently stay at lower levels, duration tends to increase (please note the duration axis is inverted).

If the duration of the index is lower, a risk within the index is reduced and therefore the risk premium is, likewise, reduced. The natural question that follows is: has the risk premium been reduced by an appropriate amount?  Toaddress this, we take the risk premium and divide it by the units of duration to come up with a premium per unit of duration risk.

The charts above show longer-term measures, the last ten-years, pre-GFC, and during the zero-interest rate policy (ZIRP) periods (ZIRP is 12/16/08-12/15/15 and 3/16/20-3/14/22 weighted by days). As all periods except the pre-GFC period imply, spread per unit of duration (risk) is tighter than average, and when looking pre-GFC, they are currently roughly in line with average.

Spread per unit of duration opinion: Spreads are tight. Investors are not being compensated appropriately.

The default rate (speculative grade) has also been somewhat moderate, and is expected(by Moody’s) to revert back to the average this year.

Should the average default rate revert to its average, then one might reasonably expect that the risk premium required for this risk should also be about average.

Default Rate based opinion: Spreads are adequate.

Of course, the default rate isn’t the only determinant of quality. As the following table from Bloomberg shows, credit quality for investment grade issuers has eroded somewhat.

Source: Bloomberg Finance LP, Bloomberg Intelligence

This trend can be seen by EBITDA leverage, which is at a ten-year high, if the pandemic period is excluded (please note this is the trimmed mean, excluding the top and bottom 10 percent).

Source: Bloomberg Finance LP, Bloomberg Intelligence

Financial metric opinion: Spreads are tight. Deteriorating financial metrics do warrant greater compensation for investors who have not yet seen it.

Finally, we can simply look at a standardized spread level (Z-score) for the various fixed income sectors (yes, a non-relative measure or relative to itself).  As the table below shows, while credit is tight, nearly everything is! A notable exception is in mortgages, where we continue to have an overweight.

In our opinion, investment grade credit spreads are currently tighter than is warranted. Should there be a more pronounced economic slowdown, continued deterioration of financial metrics, or a general souring on the sector, spreads could go wider and dent returns. That said, the following chart explains a significant amount of the spread tightening and why it remains at its current levels despite these risks. Yield. Simply put, there is demand for the product because of the yield available to investors. As the majority of fixed income returns are driven by the coupon cash flow, returns to the credit sector should be somewhat attractive in the coming year (or longer).

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