Our Head of Corporate Credit Research shares four reasons that he
believes credit spreads are likely to stay near their current
lows.
----- Transcript -----
Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of
Corporate Credit Research at Morgan Stanley. Along with my
colleagues bringing you a variety of perspectives, today I'll be
talking about why being negative credit isn’t as obvious as it
looks, despite historically low spreads.
It's Friday, July 19th at 2pm in London.
We’re constructive on credit. We think the asset class likes
moderation, and that’s exactly what Morgan Stanley forecasts
expect: moderate growth, moderating inflation and moderating
policy rates. Corporate activity is also modest; and even though
it’s picking up, we haven’t yet seen the really aggressive types
of corporate behavior that tend to make bondholders
unhappy.
Meanwhile, demand for the asset class is strong, and we think the
start of Fed rate cuts in September could make it even stronger
as money comes out of money market funds, looking to lock in
current interest rates for longer in all sorts of bonds –
including corporate bonds.
And so while spreads are low by historical standards, our call is
that helpful fundamentals and demand will keep them low, at least
for the time being.
But the question of credit’s valuation is important. Indeed, one
of the most compelling bearish arguments in credit is pretty
straightforward: current spreads are near some of their lowest
levels of several prior cycles. They’ve repeatedly struggled to
go lower. And if they can’t go lower, positioning for spreads to
go wider and for the market to go weaker, well, it would seem
like pretty good risk/reward.
This is an extremely fair question! But there are four reasons
why we think the case to be negative isn’t as straightforward as
this logic might otherwise imply.
First, a historical quirk of credit valuations is that spreads
rarely trade at long-run average. They are often either much
wider, in times of stress, or much tighter, in periods of calm.
In statistical terms, spreads are bi-modal – and in the mid 1990s
or mid 2000’s, they were able to stay near historically tight
levels for a pretty extended period of time.
Second, work by my colleague Vishwas Patkar and our US Credit
Strategy team notes that, if you make some important adjustments
to current credit spreads, for things like quality, bond price,
and duration, current spreads don’t look quite as rich relative
to prior lows. Current investment grade spreads in the US, for
example, may still be 20 basis points wider than levels of
January 2020, right before the start of COVID.
Third, a number of the key buyers of corporate bonds at the
moment are being driven by the level of yields, which are still
high rather than spread, which are admittedly low. That could
mean that demand holds up better even in the face of lower
spreads.
And fourth, credit is what we’d call a positive carry asset
class: sellers lose money if nothing in the market changes.
That’s not the case for US Treasuries, or US Equities, where
those who are negative – or short – will profit if the
market simply moves sideways. It’s one more factor that means
that, while spreads are low, we’re mindful that being negative
too early can still be costly. It’s not as simple as it
looks.
Thanks for listening. If you enjoy the show, please leave us a
review wherever you listen and share Thoughts on the Market with
a friend or colleague today.
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