United States
Are credit spreads too tight?
Investment grade yields are around their highest levels in over a decade, but spreads are at some of the narrowest (Figure 1). However, we see three key reasons why the opportunity to buy credit at a 6% yield may be superior to buying at a lower yield and wider spread.
Figure 1: Yields are at multi-year highs, but credit spreads are at multi-year lows1
1) Wider spreads may not mean higher yields, and waiting could be costly
Credit spreads often move in opposite directions from the Treasury yields they are measured against, with correlations at -0.33 since 1990 and -0.11 since the pandemic. This has helped keep all-in yields largely uncorrelated with credit spreads (Figure 2).
This is because when credit spreads tend to widen (during “risk off” periods or economic slowdowns), government bonds yields have tended to fall. As such, if credit spreads widen, overall credit yields may not rise accordingly.
Figure 2: Credit spreads have been negatively correlated with yields1
Further, waiting can cost. It is not unprecedented for credit spreads to remain low for multiple years. Spreads remained below 1% between October 2003 and June 2007, during which the asset class delivered a cumulative return of 14.5%, despite a rising rate environment (Figure 3). “Time in the market” can beat “timing the market”. We believe that at this stage of the cycle, investment grade credit may offer a particularly compelling combination of carry and high credit quality.
Figure 3: Spreads can stay low for multiple years2
2) Fundamentals may justify relatively tight spreads versus history
Credit fundamentals look healthy to us. Corporate EBITDA margins are secularly the highest since the 1990s. Interest coverage ratios are also historically strong, albeit they have been moderating since the pandemic. Net leverage has also been moderating.
Figure 4: Credit leverage metrics look solid3
The credit quality of new investment grade supply is also improving. The share of AAA to A rated non-financial issuance has climbed in recent years and surpassed the level of BBB issuance so far this year.
Figure 5: The credit quality of investment grade issuance has improved4
3) Favorable technicals may help deliver performance in the near-term
Investment grade issuance was low in 2022 when the Fed began hiking rates. However, it picked up over the last two years (Figure 6), providing a technical headwind. However, demand has encouragingly picked up significantly to meet it. Year-to-date, inflows into investment grade funds and ETFs have outpaced those into all other asset classes apart from leveraged loans as a percentage of assets under management (Figure 7).
Figure 6: Supply has risen5 Figure 7: But demand has also risen to meet it6
We expect the technical picture will remain encouraging. A record $6trn remains in money market funds7, and we expect significant proportions of this capital to trickle into longer-dated fixed income assets as rate cuts take effect. Additionally, we believe there remains the potential for foreign flows to increase if hedging costs were to revert to attractive levels for foreign buyers.
We believe an active approach can help extract remaining value in spreads
We believe an active approach can help capture remaining opportunities for spread compression as well as help mitigate threats posed by spread widening in certain names or sectors.
For example, spreads remain relatively wide in the utilities sector, is partly a result of higher levels of recent issuance in the sector (Figure 8), implying potential carry-related opportunities. Further, spreads in the financial sector are still to revert to their levels from before the 2023 regional banking crisis. So we see some potential from spread compression in well-selected credits in these sectors.
Figure 8: Utilities may offer value and financial may have room to recover8
We also believe active investors can deliver potential alpha from curve positioning. In our view, the long end offers the least value, while intermediate maturities may offer opportunities to benefit from potential curve re-steepening as rate cuts take effect (Figure 9).
Figure 9: Positioning for credit curve steepening may be beneficial as long end looks rich to us9
Conclusion – investment grade credit is worth considering
With yields at historically high levels, and rate cuts on the horizon, we believe it is a compelling time in the cycle to consider allocations to investment grade credit. We believe it is a high-quality spread product with potentially compelling fundamentals. We believe that returns from carry may be higher than those from spread compression, so waiting for credit spreads to widen may not be an optimal strategy.
