ICE BofA US Corporate Index Option-Adjusted SpreadFRED
Deskripsi
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Since credit has far greater potential to create systemic issues than does equity, corporate credit conditions are much more important to the Federal Reserve (Fed) than changes in equity prices. If you have interest in macro, monitoring and understanding the basics of corporate credit is a must have skill. If there is any one thing that might actually cause a Fed pivot, it is disfunction in this market.
There is a significant amount of current commentary around the sharply higher all-in-yields of high yield (HY) and investment grade (IG) corporate debt. In most cases the pieces conflate extreme price weakness in the large credit ETFs (HYG & LQD) with credit distress. Most pieces seem to conclude that the declines are linked to declines in credit quality and highlight financing problems in the sector. Most of that commentary suffers from a misunderstanding of the relationship between credit and Treasury spreads, what the price declines/yield increases are communicating about macro conditions, and how vulnerable companies, particularly IG companies, are being forced to refinance into a higher rate environment.
In February 2022 I published a piece on credit conditions that covered using the TradingView platform to monitor secondary market credit spreads and conditions, why the declines in most credit ETFs had nothing to do with credit quality, and the basics of monitoring credit on the platform. That piece is linked below.
The short course: 1) Corporates trade at a yield spread to treasuries. The spread compensates the corporate debt investor for the higher risk of default. 2) If Treasury yields rise, their dollar price declines. Since corporates trade at a yield spread to treasuries, if treasury yields rise, so do corporate yields (prices decline). 3) Since corporate spreads are generally far less volatile than Treasury yields, in most time periods, corporate total returns are driven by changes in Treasury yields rather than changes in corporate spreads. 4) The lower the credit quality, the wider the spread or default compensation. For instance, BBB rated corporates have more credit risk and thus more spread/yield above Treasuries than A rated bonds, 6.27 verses 5.65%. The difference of 62 basis points is the markets compensation (risk premium) for owning the riskier bond.
The chart is a weekly chart of the option adjusted spread (OAS) of the ICE BofA Corporate Index back to the 1997 index inception. OAS is the standard way of assessing the credit spread compensation over and above the Treasury rate. The higher the OAS, the more compensation the investor receives. The bands are plotted 1 and 2 standard deviations above and below the from inception date median value. The large spikes higher in 2008 and 2020 are the great financial crisis and the pandemic. Spread compensation is only now back to the long term median. This after spending most of the last decade trading nearly a standard deviation rich to the long term median. I view this as the residual of the Feds QE translating to richer than normal asset prices.
In short, there is no evidence of credit distress in the broad IG market. There is also, at least in this chart, no compelling value argument to be made. However, credit spread is only part of the equation. Remember that corporate total returns are more a function of changes in base or treasury rates than in changes in corporate spreads.
In the next installment we will focus on the IG and HY markets in detail, some fundamental observations and finally, the correlation between rates and the major credit ETFs.
And finally, many of the topics and techniques discussed in this post are part of the CMT Associations Chartered Market Technician’s curriculum.
Good Trading: Stewart Taylor, CMT Chartered Market Technician Taylor Financial Communications
Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.
Super interesting, informative and high-quality post as always! Thank you for taking the time to post this.
Here's my counterpoint to the premise that there is no distress in the corporate bond market because there is not a high option-adjusted spread (OAS): It assumes that the base rate will continue to be perceived as risk-free in the coming recession. If the base rate is no longer perceived as risk-free, then you can have a low option-adjusted spread, but still have major problems for corporate debt. If the base rate is rising at the fastest rate of change in history, is a relatively low option-adjusted spread for corporate debt really all that reassuring?
This discussion is not all that different than the one regarding the delay in the yield curve inversion between the 10-year and 3-month treasury yields. When these invert it is a reliable recession predictor. Until recently the inversion had not occurred creating a false sense of security that perhaps the Fed could tighten without a recession ensuing. However, the reason why these yields weren't inverting was not that the 3-month yield wasn't rising rapidly, but because the normally more stable 10-year yield was rising more rapidly. This is the worst reason for an inversion not to occur: markets were pricing in higher interest rates for the long term more so this tightening cycle than in any other recent tightening cycle.
Remember that rising interest rates = declining money supply, since interest rates merely reflect the cost of money. Since the stock market tends to track the money supply, a prolonged period of higher rates is a headwind for future returns.
With a lag effect, a declining money supply could cause a contraction of corporate earnings. In a normal set of circumstances, corporations can only ever earn some subset of the total supply of money. If that supply of money is shrinking, corporate earnings are likely to follow suit. How might declining corporate earnings pair with much higher yields on corporate debt (even if the yield on that debt is only a small degree higher than treasury yields)?
So in summary, I would definitely not look at a relatively low OAS as an all-clear for corporate debt, if anything I think it reflects that the coming recession will be one in which sovereign debt itself becomes a problem. (From a more scientific/research-based perspective, what you're likely seeing is called a false negative in using OAS as a measure of the health of corporate debt. Every measurement tool's sensitivity and specificity are limited). If sovereign debt is a problem, since all other debt is riskier, then the problem is some degree worse for all other risk assets. When sovereign debt becomes a problem the main winner, according to Exter's pyramid and Mises' Regression Theorem, is physical gold.
As an increasingly scarce digital commodity or digital gold, Bitcoin may stand to win, too.
CMT_Association
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@spy_master, A lot unpack so let me just concentrate on a couple of points. 1) I don't think I said that an OAS at long term median is an all clear. I think I said that it doesn't represent the sort of stress that would draw the Feds immediate attention in terms of a pivot and that spread valuations were neutral. Its a fair point that all-in-yield is important. But understand that the maturity cliff in investment grade debt isn't steep. Companies used the ultra low rate environment of the last two years to refinance massively resulting in interest coverage reaching a historic high. At least for the next few years there is a huge cash cushion and finance needs are low. I will cover some of this in the next part.
I think your other argument is that OAS isn't reliable if the risk free rate is wrong due to a steep rise in sovereign credit risk. I would agree, but I don't think that is an immediate concern. That isn't why (at least in my opinion) that rates are rising now. Maybe at some point it becomes a concern (as in Britain last month), but that isn't currently the case in the US.
Nice to know that someone thoughtful is reading.
CMT_Association
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@spy_master, I would also say that at this point in time your near term view on corporate debt is mostly a rates call. If you think rates are likely to fall, IG corporates at +160 bps are a decent place to express the view.
SpyMasterTrades
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@CMT_Association, Thank you for the response and the additional thoughts. Hopefully, my comment did not come across as a criticism. I love your insight and always closely read every post that you write! Look forward to Part 2.
CMT_Association
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@spy_master, I viewed it as discourse and not criticism. One of my largest regrets in retirement is not having the constant give and take with my colleagues. It made for better investors. I am now a committee that consists of myself.
LUC_Capital
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@spy_master, Agree with everything apart from the last part. Gold, by definition, is valuable because it's value is unanimous, however Bitcoin, as scarce as it may be, has no such consensus. To say that for any given person at any given time BTC has a value is a false proposition.
SpyMasterTrades
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@LUC_Capital, Thank you for your thoughts! Correct, Bitcoin's inherent value definitely does not have as much consensus as gold's inherent value currently. But in the future that will likely change, especially once Bitcoin's stock to flow surpasses that of Gold's in 2024. One thing to consider also is transparency. No one can audit central banks' gold reserves in the vaults. Thus, the public's trust in gold as a backing of currency will inherently always involve skepticism. Yet, Bitcoin's public, decentralized blockchain solves this transparency problem. Only time will prove to what extent Bitcoin will displace the existing monetary system. One thing I think everyone can agree on is that many central banks will likely seek to stop people from converting fiat money into Bitcoin, should Bitcoin challenge the system.
LUC_Capital
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@spy_master, Interesting points, and I completely agree transparency is one of BTC's pillars of success, it was the focal point of the birth of BTC in it's whitepaper by SN. And no need for speculation on whether banks will want to stop the adoption of BTC, it happens very often and Santander recently has controversially limited transactions to crypto exchanges based off of a factor which they themselves are guilty of facilitating.
However, I'm thinking about it from a more logical point of view, as the argument for digital gold (BTC) and physical gold can be quite confusing when it comes to inherent value. Saying that gold always has value to everyone is an axiom, however the same cannot be said for BTC as it cannot be taken to be true in every sense, or at least in a sense in which will always hold. We can thus conclude that, logically, BTC can never be compared in terms of value to gold in the same definition. Whether that distinguises it from a commodity to more of a risk asset in general, that is not for me to decide.