22 October 2021 Credit

It’s Goldilocks Time for Corporate Credit

(3 min read)

Summary

The Atlanta Fed GDPNow model may project 3Q GDP falling to 0.5% but we see little risk of credit spreads widening.
Historically, credit spreads have not been sensitive to fluctuations in quarterly GDP – apart from recessions. The Fed may be starting to unwind easy monetary policy – but it also doesn’t want to cause the next recession.
The trailing 12-month default rate is 2.6% and Moody’s expects to fall to 1.5%-1.7% during 1H 2022. Credit spreads will remain tight until something happens to change that outlook.
Credit spreads appear tight relative to the still elevated level of the VIX. Our guess now is that VIX will gradually decline as the economy moves beyond Covid stresses over the coming year

Investment Implications

We recommend investors looking for interest income hold corporate bond ETFs – LQD for investment grade and HYG or JNK for high yield.
We caution corporate bonds offer carry, but little upside from tightening spreads. Rising rates will also hurt total return performance, but high yield is less vulnerable to rate risk.

The Atlanta Fed’s latest GDPNow forecast for 3Q GDP is a scant 0.53% – a considerable drop from 6.7% in 2Q. That’s hardly consensus – Blue Chip Consensus is 3.7% and the Conference Board is at 3.5%.

The more important point is the economy is clearly slowing, and those consensus forecasts are likely to move toward the GDPNow forecast. This isn’t the place for a detailed analysis of why, but some contributing factors are the end of extraordinary fiscal support, supply chain snafus and a weak labor market.

If the economy does follow something like the GDPNow forecast, can we expect credit spreads to come under widening pressure?

Just to set the stage credit spreads are near the tights of the past 20 years. IG is at 89 bp and high yield is 302 bp (Chart 1). That’s inside many people’s comfort level. Or to put it another way – they think credit spreads are going to blow up – it’s just a question of when.

As Chart 1 shows, credit spreads do blow up from time to time. The primary catalyst is recessions. But between recessions, the quarter – to-quarter fluctuations in GDP don’t have much bearing on credit spreads (Chart 2). In large part this is because GDP is only released quarterly and is backward looking, while credit spreads are updated daily and are forward looking. That said, credit spreads don’t seem to anticipate GDP fluctuations either.

What Does Drive Credit Spreads

The primary drivers of credit spreads are defaults and equity volatility.

As Chart 3 shows, when default rates rise credit spreads widen. Actually, credit spreads lead defaults. This is largely because the standard default measure is a backward looking trailing 12-month default rate. Credit spreads and default rates rose sharply during the three recessions. There were also more minor jumps in defaults and credit spreads in 2011 (due to a cluster of defaults by weak companies that survived the financial crisis) and 2016 (when collapsing oil prices set off a wave of default among shale producers).

Today the trailing 12-month default rate is 2.6% and Moody’s projects it could fall to 1.5%-1.7% during 1H 2022. There are plenty of worrisome uncertainties in the months ahead but barring some unforeseen economic shock or crisis there is little on the horizon to suggest that they will translate into a meaningful uptick in corporate defaults.

A real time indicator of high yield spreads is the VIX, a measure of short-dated equity volatility. When it spikes and drops, high yield spreads usually follow. One period when the relationship seemed to break down was in 2016 when spreads widened on a more sustained basis but as noted this was due to sector-specific rather than systemic factors.

A second anomalous situation is now, where the tightening of high yield spreads appears to be front-running the VIX. If there is a case for wider high yield spreads it may be the sustained elevation of the VIX even as equity markets push higher. Our expectation now is that the VIX will gradually decline as the economy normalizes over the next year.

Goldilocks is Coming!

Coming back to slowing GDP, this may actually be a Goldilocks environment for credit. As long as the economy avoids recession, defaults will remain low. The Fed may be sounding more hawkish and markets anticipate rising rates over the next couple of years, but it is also highly likely the Fed will do what it has to do to avoid being the cause of the next recession. And a sluggish economy may also crimp corporate profits, making equities less attractive.

We continue to recommend investors looking for interest income hold corporate bond ETFs – either LQD for investment grade or HYG or JNK for high yield. We prefer high yield.

We caution there is little upside from tightening spreads at this point in the cycle. Total return performance will also be hurt if rates rise further but this is a bigger concern for investment grade.