Can spreads ever be too tight?

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Can spreads ever be too tight?

To the extent that markets people are worried about an overheated market, their concerns are focused on US stocks. The S&P 500 is not yet quite as expensive as it was in the zero-rate, fiscal bonanza, everyone-has-loads-of-cash glory days of 2021. But it is getting closer.

It is tempting, however, to argue corporate bonds are more expensive than stocks. Corporates’ spreads over Treasuries are, depending on credit rating, somewhere between almost as tight as 2021 and slightly tighter. Here, for example, are triple-B spreads (lowest rung of investment grade) and double-Bs (highest rung of junk):

Ethan wrote about tight spreads six weeks ago, and concluded that, as crowded as the corporate bond trade was, high yields, solid credit quality, and structural demand support made the spread rally look sustainable. He’s been right so far. Spreads have only tightened since.

The question then becomes: is there any limit on how tight spreads can go? At what point do they become unattractive?

On a relative value basis, the chart above makes me think that I might rather just own Treasuries. The five-and 10-year Treasury bonds both yield about 4.3 per cent. Do I want to take, say, double B credit risk for another 1.9 per cent of yield on top of that, especially when high-yield default rates, while low, are rising? Or why not go further, and take interest rate risk off the table, too, and lock in 2 per cent real return with five-year inflation-indexed Treasuries?

These are live questions for me. Too much of my personal savings is in cash. It is earning 5 per cent now, but I’m worried that won’t last. I need to do something, and I have plenty of stocks as it is.

Part of the issue here is that my background is in equities. If the expected return on stocks was only 2 per cent higher than the risk-free rate, I would run the other direction. But obviously the risk/return structure of bonds is very different.

Marty Fridson, of Lehmann Livian Fridson Advisors, remains the most value-conscious corporate bond analysts. He argues spreads have ceased to make sense. He notes the most important determinant of spreads historically has been credit availability. This is logical both because debt becomes a problem to the degree it is difficult to refinance, and because credit availability varies with economic growth. Lately this relationship looks out of whack. This chart below uses the Federal Reserve’s senior credit officer survey net level as the proxy for credit availability. As you can see at right, bank credit is still restricted, but spreads don’t care. The gap between the two was only wider in 2021:

This chart shows that this in an extraordinary moment for corporate credit demand. After years of very low rates, nominal and real rates are reasonable again, and the Fed has signalled to investors that rates will come down in time. There is a headlong rush among investors to rebalance portfolios to a mix of assets that zero rates had made very difficult to maintain. Pension funds and insurance companies, in particular, have an opportunity to lock in an asset mix that matches their liabilities.

But while demand may explain spreads, it does not justify them. I asked Bob Michele, head of fixed income for JPMorgan Asset Management (his Unhedged interview from January is here) if he could make sense of the spreads this narrow. His reply:

Right now, investors are looking at the all-in-yield rather than credit spreads. Investment grade corporate bonds at a yield of 5.5 per cent at the index level are appealing to investors as an alternative to cash — especially if the Federal Reserve will cut interest rates this year. High yield at a yield of 8 per cent looks even better…

Credit spreads of 95 basis points in investment grade corporates and 325 bps on high yield are towards the tighter end of their long-term ranges, but history shows that they can stay there for a long time — as long as we continue to be in an economic environment of trend growth and moderate inflation. In the period of 2004-2007, investment grade credit spreads traded between 80-100 bps over comparable Treasuries. Also during that period, a lower-rated high-yield market traded consistently between 250-350 bps over comparable Treasuries.

So we think credit spreads will continue to narrow as long as the soft landing continues to unfold. This is our base case expectation. The biggest risk to our forecast is that the US economy ultimately rolls into recession. In a recession, we would expect credit spreads to double from where they are today.

Michele’s reply captures both sides of the coin. Absolute yields are very high now, and it is yields, not spreads, that ultimately determine the bulk of returns. And spreads can stay tight for a long time in benign conditions. But with spreads so tight, they could double if something went wrong, which would move prices dramatically downward.

Columbia Threadneedle’s Ed Al-Hussainy pointed out to me that it is important to put this spread question in the context of portfolio goals. An investor with an infinite time horizon and unlimited tolerance for volatility, — if there is such a thing — should hold 100 per cent equities regardless. Stocks will return more over the very long run. So it makes sense, in a way, to think about equities in isolation: how does their current expected return compare to historical averages? But a bond investor is almost by definition one who is trying to hit certain return and risk benchmarks within a certain time horizon. That is why they have chosen or diversified into a steadier, lower-returning asset class. So you have to specify goals before saying whether credit is too expensive or not. Credit, unlike stocks, is never simply cheap or expensive. Of course portfolio constraints matter to equity investors too, but the distinction holds all the same.

So the question for investors — and for me in particular — is whether the volatility associated with a sudden and large change in spreads would bring to a corporate bond portfolio is tolerable. Al-Hussainy argues that as long as they can hang on through the volatility in spreads, investors who stay near the investment-grade line in a diversified portfolio of corporate bonds are highly unlikely to suffer large permanent losses from defaults. But courage and time is required.

In that sense, even when spreads are very tight, they represent extra return to a truly patient and volatility-tolerant investor. At a moment such as now (where real yields are high and corporate balance sheets are solid) it can still makes sense to grab them. They are a harvestable risk premium.

The same is not true at the lower reaches of the credit spectrum, of course, and it is interesting in this context that triple C rated bonds spreads have not rallied to the wild 2021 levels. Where there is real risk of loss to even patient and volatility-tolerant investors, the market has mostly kept its head:

It would be nice if spreads were wider, and at its current price corporate bond prices are vulnerable to dislocation. But the rally isn’t crazy.

One good read

Mosques, Temples, and India’s election.

This post was originally published on Financial Times