The economic fallout from the coronavirus crisis becomes more apparent by the day. Yet equity markets have rallied impressively off March lows, apparently bolstered by some combination of extraordinary Fed policy actions and perhaps faith that the US economy will get back on its pre-virus track by early 2021.
Credit markets have largely followed along, although the view from that angle is somewhat less sanguine – at least as this is written. In the charts below, we look at a long-term (25+ years) perspective and year-to-date performance. The former lens suggests that we are entering another major default cycle. The latter is cloudier but opens up the possibility that current credit spreads are less about defaults and more about overall market volatility.
Two Cycles, Two Credit Spread Scenarios
Over the past 25 years there have been two major default rate cycles: 2001-02 and 2008-09. Both were similar in magnitude, although the 2001-02 cycle was spread out over a longer timeframe. As charts 1 and 2 below show, investment grade (IG) and high yield (HY) spreads performed very differently during these cycles. In the earlier cycle, IG and HY spreads peaked at 250 bp and 1070 bp, respectively; in 2008 they soared to more than twice those levels.
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The economic fallout from the coronavirus crisis becomes more apparent by the day. Yet equity markets have rallied impressively off March lows, apparently bolstered by some combination of extraordinary Fed policy actions and perhaps faith that the US economy will get back on its pre-virus track by early 2021.
Credit markets have largely followed along, although the view from that angle is somewhat less sanguine – at least as this is written. In the charts below, we look at a long-term (25+ years) perspective and year-to-date performance. The former lens suggests that we are entering another major default cycle. The latter is cloudier but opens up the possibility that current credit spreads are less about defaults and more about overall market volatility.
Two Cycles, Two Credit Spread Scenarios
Over the past 25 years there have been two major default rate cycles: 2001-02 and 2008-09. Both were similar in magnitude, although the 2001-02 cycle was spread out over a longer timeframe. As charts 1 and 2 below show, investment grade (IG) and high yield (HY) spreads performed very differently during these cycles. In the earlier cycle, IG and HY spreads peaked at 250 bp and 1070 bp, respectively; in 2008 they soared to more than twice those levels.
Spreads during the 2001-02 cycle reflected the credit and default risk in the market. In 2008 (with hindsight) credit and default risk were similar; the differentiating factor was the Lehman default. Lehman was a large player in the total return swap market, which was based on its bond index product. Many investors took long positions in the corporate bond index, and Lehman hedged its exposure by holding corporate bonds. When Lehman collapsed that inventory was dumped onto the market. The blowout in spreads beyond 2002 levels was a liquidity event rather than a reflection of credit risk.
Chart 1: IG Spreads Matching 2002 Levels
Source: St Louis FRED, Macro Hive
Chart 2: HY Spreads Are Now Inside 2002 Wides
Source: St Louis FRED, Macro Hive
A Cushion for the CCC Cohort?
The interesting point about today’s credit spreads is that they are near 2001-02 levels. IG spreads are at the 2002 wides; HY is somewhat inside those levels. What’s really keeping HY relatively tight is the triple-C cohort (Chart 3), which is trading well inside 2002 levels. The most likely explanation is that small energy companies and shale producers dominate the lower echelon of the corporate bond market, and there is some confidence in the market that the government will somehow shelter the industry from the worst of the oil price bust.
Chart 3: Low-rated Energy Companies May Avoid Worst Slump of All
Source: St Louis FRED, Macro Hive
The obvious conclusion is that after an initial widening in March as the equity selloff accelerated, credit spreads are pricing in a default cycle similar to the previous two.
This Cycle Really is Different
A closer look at daily activity during the past couple of months provides more nuance.
On 21 February, as equities reached all-time highs, credit spreads traded near cyclical tights. Since then, IG and HY spreads have moved roughly in parallel (Chart 4). They widened until the Fed announced its first major policy action on 23 March (cutting rates to near zero and resuming quantitative easing), and then have recovered somewhat to near 2002 wides (as noted above).
Chart 4: IG and HY Have Moved in Parallel…
Source: St Louis FRED, Macro Hive
There is little question that credit markets have followed equities (Chart 5). This is a departure from previous credit cycles, where credit usually starts widening late in the cycle even as equities continue to rally, due to rising leverage and rating downgrades.
Chart 5: …Roughly in Line With Equities…
Source: St Louis FRED, Macro Hive
Another factor driving spreads wider was the extraordinary Treasury market rally between 23 February and 9 March when yields dropped by 100 bp and more (Chart 6). Generally speaking, when Treasuries move to sharply lower levels, credit spreads often lag, partly because of limited liquidity, but also because many corporate investors often have yield bogeys relative to their cost of liabilities. Arguably, most of the widening between 23 Feb. and 9 March in IG could be attributed to being left behind by the Treasury rally. And some of the recovery since then is adjusting to lower yield levels.
Chart 6: …and in Response to Treasuries and Fed
Source: St Louis FRED, Macro Hive
Did the Fed Blow Up the Default Cycle?
Last but not least is the Fed’s aggressive steps to backstop the credit markets through its new lending programs announced on 9 April. The intent is presumably not to bail out corporate America but to provide liquidity during a period of extraordinary stress to companies that would have probably weathered a normal recession. But the overall effect will surely be to prevent any number of weak companies from going bankrupt and defaulting. It remains to be seen, but it could be that rather than a credit market bust it will be the default cycle that goes bust – at least this time around.
If that is the case, there is a good case that credit spreads today reflect not a likely default cycle but the various technical vagaries of Treasuries, equities and volatility – and could trend tighter.
Credit Spreads Mean What They Mean
An analyst’s first instinct is to look to previous economic downturns and recessions for clues to interpreting how the coronavirus crisis might play out for markets. But the nature of this economic collapse, market meltdown, and policy response makes it all but impossible to look to any post-war recession scenario for guidance.
If credit spreads settle near present levels or leak wider, we would be comfortable interpreting that as heralding a significant credit default cycle over the next year. But if spreads keep bouncing around largely in response to equities and Treasuries, we will learn in due course just what that means (along with everyone else).
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)