Credit Market Outlook: It’s All About Carry Now

Summary

• The corporate bond market outlook is sanguine. Credit spreads are near the past decade’s tights and likely to remain in a narrow range for now. Any upside now is mostly limited to the carry relative to Treasuries.
• The primary risk is a collapse into recession. But that scenario will require some sudden and unexpected exogenous event apart from the ongoing coronavirus crisis.
• Investors can use ETFs to get exposure to investment grade (LQD) and high yield (HYG, JNK) markets.

Corporate Bond Market Is Fine

The corporate bond market pretty much followed equities in 2020. Spreads gapped out to solid recession levels when the coronavirus lockdowns hit in March. After a quick bounce back, IG and HY spreads traded in a range throughout the summer then tightened in several steps to close out the year near 100 bp for investment grade and 400 bp for high yield (Charts 1a and 1b).

Indeed, the latest rally was strong enough that both the investment grade and high yield markets handily outperformed their historical relationship with the VIX index of short-dated implied equity volatility.

Yellow Flags Ahead…

The rally does raise some yellow flags. The still-elevated level of VIX clearly indicates that a critical mass of investors remains positioned for or hedged against downside risk given the weak economy and uncertain outlook for the coronavirus. That risk is real, and should it materialize corporate bonds will sell off sharply, along with equities. Whether that selloff proves to be a temporary dislocation or more lasting would depend on what caused the selloff.

Still, the more likely scenario in our view is that the VIX gradually trends lower as more people are vaccinated and new infections decline.

A second yellow flag is the sharp decline in yields. The investment grade index now yields 1.8% – and the real yield is a negative 12 basis points! The high yield index yields 4.3%, with a real yield of 2.4%. At the beginning of December, the high yield index yield was 4.75% and 3% on a nominal and real basis, respectively. It remains to be seen how much appetite there is for corporate credit at these levels.

…But Underlying Support is Strong

Despite lingering concerns about another selloff and low yields, other factors should support the corporate credit market at these levels.

Defaults are falling. Barring another collapse in the economy, defaults have peaked for this cycle. We will explore the default rate outlook in more detail in a subsequent article, but the short of it is that the peak bond default activity in the high yield market occurred earlier this year following the economic collapse that accompanied the national lockdown policy. Barring a sudden recession scenario defaults will remain low, and credit spreads will stay near the tight end of the range.

Issuance is easing. A second source of support for credit markets could be a more measured pace of new issuance after the fevered pace of 2020. Corporate issuance totalled about $2.4 trillion versus a more normal run rate near $1.5 trillion (Chart 2a). Issuance swelled after the Fed cut rates in March and signalled a willingness to buy investment grade corporate bonds. Demand was robust, but then spreads were wider then and yields were in the 2.5%-3% range for IG and 6%-8% for high yield.

Recently, monthly issuance has been consistent with an annual rate of about $2 trillion. While higher than normal, it does show that companies aren’t issuing willy-nilly just because rates are low. Corporate treasurers tend to be savvy about taking advantage of windows when market conditions are favourable – meaning rates are attractive and there is robust demand. The slower pace of issuance probably has as much to do with investor appetite as with corporate demand for funds.

Outstanding nonfinancial debt (bonds and loans) jumped about 15% in 2020, after rising about 6% annually in recent years (Chart 2b). Half of this was due to loans, with companies drawing down credit lines in March as insurance against what appeared to be a major recession brewing.

We expect outstanding nonfinancial debt to stabilize or even decline in 2021. Companies have been and will continue repaying bank loans. And we think that the heavy pace of issuance in 2020 was in part to pre-fund maturing debt issues in the coming year. To the extent that is the case, outstandings should decline, and that should ease concerns that companies have become overlevered.

It’s all About Carry

At this point the corporate credit market is attractive for investors who are primarily looking for a steady source of carry. There is limited upside from tighter spreads or lower yields. Indeed, the risk is that yields move higher in the coming year. For investors who don’t invest directly in corporate bonds, there are several corporate bond ETFs that trade on the equity markets:

*SEC yield is a standard measure of yield less expenses and capital gains/losses.

The primary risk is that the economy falls back into recession. We doubt any recession would be caused by coronavirus-related factors given the likelihood of at least some ongoing fiscal support and the Fed backstop. Rather it would be due to some exogenous and unexpected shock, although the coronavirus crisis could exacerbate it.

We are Neutral

We are neutral on corporate bonds at current levels. They are attractive primarily as a source of carry relative to Treasuries.