After trading in a narrow spread range near 500 bp since early October, the corporate bond high yield market has rallied sharply since the election to 422 bp (Chart 1). We think the rally has room to run, although the easy money has been made.
In late September, high yield spreads widened to about 550 bp in response to an equity market selloff and concerns that further stimulus was not forthcoming. We published a note at that time suggesting that high yield looked attractive.
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Summary
- High yield credit spreads gapped 80 bp tighter to 422 bp following the election, reaching a target we set in late September when spreads were near 550 bp.
- As long as the economy remains in growth mode, high yield spreads can grind tighter.
Market Implications
- We view high yield as attractive for yield and carry at present levels and for a medium-term hold.
- Credit investors may want to add to positions; cross-asset investors may find better opportunities in equities.
After trading in a narrow spread range near 500 bp since early October, the corporate bond high yield market has rallied sharply since the election to 422 bp (Chart 1). We think the rally has room to run, although the easy money has been made.
In late September, high yield spreads widened to about 550 bp in response to an equity market selloff and concerns that further stimulus was not forthcoming. We published a note at that time suggesting that high yield looked attractive.
Our rationale was that even though the 12-month trailing default rate was (and still is) projected to continue rising until early 2021, the underlying monthly default rate had likely peaked and would drop sharply. On the basis of that outlook, we projected that high yield spreads could tighten to the 400-450 bp range in coming months.
Now that we have reached that tantalizing target range, is high yield still a hold? Or even a buy?
As long as the economy avoids another recession, default rates will continue to decline; so credit risk is relatively low. In this environment, high yield spreads can remain near present levels and grind tighter. We note that before the Covid crisis hit in March, high yield spreads traded in the 360-370 bp range. We also caution that a further rally to these levels may take another six months to a year – and that is assuming labour markets and the economy continue to recover.
For investors looking for yield and carry, we think high yield corporate bonds are still attractive even if spread tightening upside is probably limited to 50 bp or so. We consider high yield credit a hold at current spread levels. Credit investors may want to add to positions even at present spread levels. Cross-asset investors may find better opportunities in equities, especially if they expect the Biden economy and recovery to be robust in 2021.
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.)