Credit spreads are at the lowest levels in more than two decades,
indicating health of the corporate sector. However, our Head
of Corporate Credit Research Andrew Sheets highlights two forces
investors should monitor moving forward.
Read more insights from Morgan Stanley.
----- Transcript -----
Andrew Sheets: Welcome to Thoughts on the
Market. I'm Andrew Sheets, Head of Corporate Credit Research at
Morgan Stanley.
Today – what to make of credit spreads as they hit some of their
lowest levels in over 20 years? And what could change that?
It's Friday, August 22nd at 2pm in London.
The credit spread is the difference between the higher yield an
investor gets for lending to a company relative to the
government. This difference in yield is a reflection of perceived
differences in risk. And bond investors spend a lot of time
thinking, debating, and trading what they think it should
be.
It increases as the rating of a company falls and usually
increases for bonds with longer maturities relative to shorter
ones. The reason one invests in credit is to hopefully pick up
some extra yield relative to buying a government bond and do so
without taking too much additional risk.
The challenge today is that these spreads are very low – or
tight, in market parlance. In the U.S. corporate bonds with
Investment Grade ratings only pay about three-quarters of a
percent more than U.S. government bonds of the same maturity.
It's a similar difference between the yield on companies in
Europe and the yield on German debt, the safest benchmark in
Europe.
And so, in the U.S. these are the lowest spread levels since
1998, and in Europe, they're the lowest levels since 2007. The
relevant question would seem to be, well, what changes
this?
One way of thinking about valuations in investing – and spreads
are certainly a measure of valuation – is whether levels are so
extreme that there's not really any precedent for them being
sustained for an extended period of time. But for
credit, this is a tricky argument. Spreads have been lower than
their current levels. They were that way in the mid 1990s in the
U.S., and they were that way in the mid 2000s in Europe, and they
stayed that way for several years. And if we go back even further
in time to the 1950s? Well, it looks like U.S. spreads were lower
still.
Another way to think about risk premiums – and spreads are also
certainly a measure of risk premium – is: does it compensate you
for the extra risk? And again, even with spreads quite low, this
is tricky. Only making an extra three-quarters of a percent
to invest in corporate bonds feels like a pretty miserly amount
to both the casual observer and yours truly, a seasoned credit
professional. But when we run the numbers, the extra losses that
you've actually experienced for investing in Investment Grade
bonds over time relative to governments, it's actually been about
half of that. And that holds up over a relatively long period of
time.
And so, while spreads are very low by historical standards,
extreme valuations don't always correct quickly. They often need
another force to impact them. With credit currently benefiting
from strong investor demand, good overall yields, and a better
borrowing trajectory than governments, we'd be watching two
dynamics for this to change.
First weaker growth than we have at the moment would argue
strongly that the risk premium and corporate debt needs to be
higher. While the levels have varied, credit spreads have always
been significantly wider than current levels in a U.S. recession;
and that's looking out over a century of data. And so, if the
odds of a recession were to go up, credit, we think, would have
to take notice.
Second, the fiscal trajectory for governments is currently worse
than corporates, which argues for a tighter than normal corporate
spread. And the recent U.S. budget bill only further reinforced
this by increasing long-term borrowing for the U.S. government,
while extending corporate tax cuts to the private sector. But the
risk would be that companies start to take these benefits and
throw caution to the wind and start to borrow more again – to
invest or buy other companies.
We haven't seen this type of animal spirit yet. But history would
suggest that if growth holds up, it's usually just a matter of
time.
Thank you as always for listening. If you find Thoughts on the
Market useful, please let us know by leaving a review wherever
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