High Yield Credit Spreads Poised to Keep Tightening

Summary

• Credit spreads are approaching decade tights. But history shows there is still some upside – especially in high yield – if the economy avoids another collapse.
• Key to this scenario is a continued decline in the VIX and a low default rate.

Market Implications

• Investors looking primarily for carry can hold investment grade credit through the LQD ETF and high yield through either the HYG or JNK ETFs.
• We think equities are more attractive for total returns at this point in the cycle.

Credit spreads continued to grind tighter in the past month. Investment grade (IG) tightened 6bp to 99bp, and high yield (HY) moved 15bp tighter to 370bp (Chart 1). Both are near the tights of the past decade. There is good reason to think credit spreads could test and go through those levels again.

First a little history lesson. HY spreads briefly traded between 330bp and 350bp in late 2018 and early 2020 before Covid-19 struck. During the heady years between 2005 and mid-2007, HY traded below 300bp and as tight as 260bp. IG traded below 90bp during that period and near 65bp in 1996-97 before the Asian currency crisis hit. IG may have difficulty reaching those tights again – it was a higher quality market then, with an average rating in the low-to-mid single-A range versus high triple-B today. But HY has room to run.

Yet the broader point is that, tight as credit spreads are, there is still some upside if the economy avoids another collapse and the vaccine allows the economy to fully reopen during 2021.

VIX Is One Source for Optimism

Corporate credit spreads have moved largely in tandem with the CBOE equity volatility index (VIX) over the past 20 years, albeit with less volatility (Chart 2)! In the past few months, this relationship has broken down, with both IG and HY spreads gapping tighter while the VIX remained in a narrow range near 25%. History suggests the VIX should be trading in the 12-15% range or lower.

Clearly some investors remain cautious and are long puts to hedge against another major selloff. If they are right, credit spreads will gap out again. At this point we think it more likely the VIX will trend lower, especially if the Biden administration can work with Congress to keep fiscal stimulus flowing until the economy fully reopens and initiate a major infrastructure program. The timing may be uncertain, but we do think both will happen.

As the VIX declines, corporate credit spreads should grind tighter.

But a decline in the VIX should also support equities. That potential upside should exceed capital gains and carry from corporate bonds.

Defaults Are Low and Supportive of Tighter Spreads

According to Moody’s, the December trailing 12-month default rate was 8.4% (Chart 2). Moody’s is now forecasting that it will fall to 7.9% during the first quarter of 2021. As recently as early December Moody’s was calling for defaults to rise to 10.1%.

In fact the default rate has already collapsed. The 12-month trailing rate is essentially the sum of the past one-month default rates. Monthly defaults peaked last summer near an annual rate of 16% but are now less than 5%. As the peak months fall out of the moving sum, the 12-month trailing default rate will converge to the annualized one-month rate (Chart 3).

We can calculate implied credit spreads based on these default rates.^[1] HY spreads followed the implied one-month default rate last spring, peaking at about 880bp when the implied spread was about 1,000bp (Chart 4). Spreads then gapped tighter as the one-month rate fell. More recently actual spreads seem to be tracking the trailing 12-month default rate, perhaps partly due to the still-high level of VIX.

If our economic and default projections prove realistic, HY credit spreads could tighten to inside 300bp over the next year – at least hypothetically.

Still, that could be a challenging target. The biggest problem is the low level of yields, which may put off some investors. The IG index yields 1.85% – and -0.25% on a real basis. HY yields 4.3%.

Corporate credit will also underperform on a total return basis if rates back up sharply. But tighter spreads will probably offset this. A rate backup will probably indicate both a stronger economy and higher inflation, which will keep defaults low and support tighter spreads.

Credit for Carry, Equities for Upside

Investors looking primarily for carry can hold IG credit through the LQD ETF and HY through either the HYG or JNK ETFs. But for upside and total return, we prefer equities at this point in the cycle.

1. The basic relationship is Spread = Default rate * (1- Recovery Rate). We assume 35% recovery rate. ↑