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What are the credit markets telling asset allocators?
What Are The Credit Markets Telling Asset Allocators? by Toby Nangle, Columbia Threadneedle Investments
Credit spreads can contain important information about investors’ expectations regarding risks to corporate solvency, and the economic cycle more generally.
Rising credit spreads can also reveal strains in the financial system that are only later reflected in equity market valuations.
We explain what the signals in the recent sell-off tell investors and what we are doing with this information in portfolio construction decisions.
Credit spreads – the additional yield promised to investors over and above the yield offered by similar maturity government bonds – can contain important information about investors’ expectations regarding risks to corporate solvency, and the economic cycle more generally. Rising credit spreads can also reveal strains in the financial system that are only later reflected in equity market valuations. As such, it is worth asking what the substantial rise in Investment Grade and High Yield credit spreads over the past 18 months (figures 1 and 2) means for investors.
Credit spreads compensate investors for a combination of underlying corporate credit risk and illiquidity risk. We have written before about a technique that is used by our investment team and the Bank of England to split credit spreads into these two components. Our analysis suggests that there has been neither an increase in theoretical liquidity risk premia embedded in credit spreads, nor an increase in empirical measures of illiquidity over the past 18 months.1 As such it would seem by process of elimination that the increase in credit spreads really is about an increase in perceived credit risk.
The increase in credit spreads has come at a time when many energy companies have experienced a very marked deterioration in their prospects. Energy is an important part of the US high yield market, accounting for around 16% of the face value of the market.
Figure 3 compares the distribution of spreads for US high yield non-energy company bonds at the end of July 2014 when the oil price stood at $98 a barrel and September 2015 by which time the oil price had fallen to c$45. We can see that substantial distress has been priced into energy company debt when we repeat the exercise for energy companies, the results of which are shown in Figure 4. This shows that we have moved from a situation where virtually no US energy company bonds traded with an option-adjusted spread above 1,500 basis points to one in which more than 15% of energy company bonds (by face value) traded with this risk premium.
Importantly, the centre of gravity for both energy and non-energy high yield bonds has also shifted higher over the period, reflecting the fact that almost every sector of the market has been repriced (downwards). And interestingly, we find that the European high yield market has also been largely repriced despite its much lower exposure to energy (as shown in figure 2). It appears to be a victim of contagion in credit markets, and while we expect the default rate to spike higher in the US market,