Most loved credit quality

monitoring investor preferences for US IG vs HY

Which US corporate bond segment is performing best?

Level

• the high yield vs investment grade credit spread ratio is sitting around its average for the observed period, signalling investors' current wait & see mood and no preference for a specific credit quality at the moment

Trend:

• since last week - investors preferences tited towards investment grade
• since last month - investors have opportunistically preferred high yield to date, but the outlook is deteriorating and things are changing

IntroThe ratio between investment grade and high yield refers to the relative difference in spreads between these two types of corporate bonds. The ratio is typically calculated by comparing the spread of high-yield bonds to the spread of investment-grade bonds.

Credit spreadsA corporate bond (credit) spread is the difference between its yield and the yield of a risk-free bond of the same maturity, typically a US Treasury in ther US or a German Bund in Europe. In more practical terms, a credit spread reflects the extra yield investors demand for holding a corporate bond, which carries a higher risk of default compared to a government bond from the same country/region.

Credit quality: HY and IGA high-yield bond is a debt security issued by a corporation that is considered to be at a higher risk of default compared to better credit quality bonds. To compensate investors for this increased risk, these bonds typically offer a higher credit spread than investment grade bonds.

An investment-grade bond is a bond that is considered to be of relatively low credit risk. These bonds are issued by entities that have a strong financial standing and a high likelihood of repaying their debt obligations. Given their lower risk, these bond typically offer a lower credit spread than high yield bonds.

Chart guideIn the chart above we monitor the current market preference for either high yield or investment grade spreads. First, we look at the overall ratio level to be compared against its long term average: if the current ratio is below the average, it means that investors have been happier to own more high yield than investment grade than in the past.

Second, we look at the latest trendline: ignoring its overall level, if the ratio is trending higher then investors are currently demanding more investment grade (and less high yield) than the days before, and viceversa if the line is drifting lower.

Market implicationsMonitoring investors' preferences in real time is useful to understand their overall appetite for risk, given the context, and can help guess what corporate bond segment is likely to have better momentum in the near term.

Higher appetite for high yield in any given time means that investors are more likely to buy stocks and risk assets, and viceversa when they turn towards investment grade. Also, a preference to investment grade may also mean an expectations for rate cuts to come from the central banks, given investment grade higher sensitivity (or duration) to interest rates vs high yield bonds.

Credit spread differentials

monitoring early signs of trouble from credit markets

Any recessionary signals on the horizon?

Reading of signals from the US IG credit curve

• in the past month the credit curve has turned flatter, with investors betting on possible troubles ahead
• in fact, credit spread differentials are thin, with longer-dated credit remunerating investors just slightly more than shorter-term maturities: the slope of the US IG credit curve remains positive and upward but flatter than normal as uncertainty over the future starts showing up

We look at US credit spreads to spot possible alerts and implications related to both the US economy and in credit markets everywhere.

IntroWe define credit spread differential the difference between the spread of two bonds (from the same issuer) with different maturities. In other words, it is the measure of the extra spread/income paid to investors for the increased risk associated with investing in later maturities.

We look at it because such differential works as a powerful (if lesser known) barometer on upcoming troubles in the economy (and markets).

Chart guideIn the chart above we look at the daily difference between the average spread paid by investment grade (IG) bonds expiring over 7/10 years minus the spread of IG bonds expiring in 1/3 years.

The ruleImagine to lend money to a high-quality company such as Microsoft or Nestle (both being investment grade): you would expect them not to default, and so it would be safe to assume that your money/capital will be safely returned to you at a later stage (plus interest). Safe but not entirely guaranteed.

The future is uncertain and anything can happen: business decisions in the future can be wrong and companies may do less well than before, eventually, making them less able to repay their entire debt back. So it is logical to perceive less risk (and demand lower spread) when lending your money to a company in the short-term (1-3 years) than in the long-term (7-10 years) as more uncertainty builds up by definition.

Given the above logic, we always expect corporate bonds with later maturities to pay a higher spread.

An example to clarify thingsImagine that Microsoft issues a 1 year bond paying 5% yield. With the 1-year US Treasury pays 4%, Microsoft would offer in the example an additional spread (on top of the US Treasury yield) equivalent to 1 % (5% - 4% = 1%; the spread is 1%, or 100 basis points - bps).

Then, imagine that 100bps spread at 1-year maturity would increase to 150bps for the Microsoft bond expiring in 3 years, 175bps over 5 years, 200bps over 7 years. This would be a normal scenario, with Microsoft investment grade bonds rewarding investors with an incremental spread to invite market participants to lend at later maturities.

In such example, the Microsoft spread differential between its 7-year bond and its 3-year bond would be 200bps - 150bps = 50bps (= 0.5%).

An alternative reading on troubles on the horizonWe said that it is normal to expect corporate bonds with later maturities to pay a higher spread. What happens if they don't?

If investors see a slow-down in growth in the future, they will demand lower spreads from corporate bonds at later maturities. And in case of a major recession (like in 2001 or 2009) investors would demand a 0bps premium, or even a lower spread, today invest in later maturities when the storm will be gone, instead of investing in earlier maturities when even high quality companies might be in liquidity troubles and may struggle to repay back the maturing debt.

This is why the normally upward sloping credit curves, with positive spread differentials as we go into the future, are a clear indicator of troubles on the horizon when the slope flattens or even invertes, meaning that differentials get closer to either 0 or go negative.

Closing remarksThe inversion of government bond yield curves gets much morew attention as a recession indicator, but - as we have seen in 2023 - the indicator is not always right and could be misliding. The flattening of the credit spread curves is instead a safer, more reliable barometer of clear troubles ahead.