EU investment grade spread drivers

finding out why spreads are moving

Are spreads trailing stocks or bonds?

In summary

• investor sentiment has been influencing credit spreads more than macro dynamics in the period, given the higher negative correlation of credit spreads with stock prices

In more detail

• looking at the past 2 weeks, This is bad news, as the two income components of EU IG bonds (the underlying yield plus the spread) have both caused losses in fixed income portfolios, spread sell-off
• focusing on spreads and bond yields, we see that spreads and yields, both higher, have a positive correlation of 0.86(increasing as of late) as they moved in the same direction very often
• focusing on spreads and stock prices, we see that higher spreads and lower stocks have a negative correlation of -0.81(softening as of late) as they moved in opposite directions very often

Zooming out:

• looking at the past six months, This is bad news, as the two income components of EU IG bonds (the underlying yield plus the spread) have both caused losses in fixed income portfolios, expectations for tighter monetary policy in a late cycle environment
• credit spreads and yields have a positive correlation of 0.58(increasing as of late)) as they moved in the same direction often
• spreads and stocks have a weak correlation of -0.27(softening as of late)): we can add that EU IG spreads are pricing-in market volatility and mounting investor uncertainties

IntroCorporate bond (or credit) spreads, the difference in yield between a corporate bond and a comparable government bond with the same maturity, can move due to a variety of factors including changes in economic conditions, investor sentiment and ad-hoc matters related to the issuing company or market conditions (such as supply/demand or liquidity for specific bonds).

Why credit spread changeGenerally, wider spreads indicate deteriorating investor sentiment and/or increased risk/greater chance of default, while tighter spreads suggest improved investor confidence or lower risk in the issuer's ability to meet its debt obligations.

What influences credit spreadsAs credit spreads can be affected by a plethora of factors, we focus here on tracking (1) their correlation with government bond yields (as a proxy of changes in economic conditions, being yields themselves driven by expected economic growth, expected inflation and subsequent changes in monetary policy) and (2) their correlation with stock prices, as a proxy for investors' sentiment.

Chart guideIn the chart we keep an eye on European investment grade credit spreads and their influencing proxy factors: we use the German 10yr yield and the equity index Stoxx 600 for our analysis.

Market implications: spreads vs yieldsWe should expect credit spreads to normally move in the opposite direction of bond yields. A short-term negative correlation with bond yields - classic - may indicate that credit spreads, are being driven by powerful macroeconomic dynamics such as changes in rate or inflation expectations. Positive correlation is weird and should be expected only in peculiar circumstances, such as a major market sell-off (both spreads and yields up) or central bank voluntary manipulation of markets (such as QE programs, when both yields and spreads move lower).

Market implications: spreads vs stock indicesWe should expect credit spreads to also move in the opposite direction as stock markets too. A short-term negative correlation with stock prices would be normal: rising equity indices, a sign of happy investors, tend to align with compressing spreads and viceversa. Positive correlation would also be unusual here, as rising stocks (positive sentiment) would not normally match credit spreads selling-off (negative sentiment) unless technical factors such as changes in the bond demand and supply are taking place. A stronger correlation with stocks, instead of yields, is a possible indication that credit spreads are currently following investors' sentiment more than macro dynamics.

EU high yield spread drivers

finding out why spreads are moving

Are HY spreads trailing stocks or bonds?

In summary

• given the irrelevant correlation readings, credit spreads have moved independently from both market sentiment (via stock prices as proxy) or macro dynamics (via bond yields as proxy), probably driven by technical factors such as supply and demand

In more detail

• looking at the past 2 weeks, EU HY spreads are pricing-in spread sell-off
• focusing on spreads and bond yields, we see that spreads and yields, both higher, have a weak correlation of 0.33(softening as of late) showing the lack of a clear relationship
• focusing on spreads and stock prices, we see that higher spreads and lower stocks have a weak correlation of -0.34(softening as of late) showing the lack of a clear relationship

Zooming out:

• looking at the past six months, EU HY spreads are pricing-in market volatility and mounting investor uncertainties
• credit spreads and yields have a weak correlation of 0.42(increasing as of late)) showing the lack of a clear relationship
• spreads and stocks have a negative correlation of -0.56(softening as of late)): we can add that we have been a in risk-off environment with expectations for tighter monetary policy

IntroCorporate bond (or credit) spreads, the difference in yield between a corporate bond and a comparable government bond with the same maturity, can move due to a variety of factors including changes in economic conditions, investor sentiment and ad-hoc matters related to the issuing company or market conditions (such as supply/demand or liquidity for specific bonds).

Why credit spread changeGenerally, wider spreads indicate deteriorating investor sentiment and/or increased risk/greater chance of default, while tighter spreads suggest improved investor confidence or lower risk in the issuer's ability to meet its debt obligations.

What influences credit spreadsAs credit spreads can be affected by a plethora of factors, we focus here on tracking (1) their correlation with government bond yields (as a proxy of changes in economic conditions, being yields themselves driven by expected economic growth, expected inflation and subsequent changes in monetary policy) and (2) their correlation with stock prices, as a proxy for investors' sentiment.

Chart guideIn the chart we keep an eye on European investment grade credit spreads and their influencing proxy factors: we use the German 10yr yield and the equity index Stoxx 600 for our analysis.

Market implications: spreads vs yieldsWe should expect credit spreads to normally move in the opposite direction of bond yields. A short-term negative correlation with bond yields - classic - may indicate that credit spreads, are being driven by powerful macroeconomic dynamics such as changes in rate or inflation expectations. Positive correlation is weird and should be expected only in peculiar circumstances, such as a major market sell-off (both spreads and yields up) or central bank voluntary manipulation of markets (such as QE programs, when both yields and spreads move lower).

Market implications: spreads vs stock indicesWe should expect credit spreads to also move in the opposite direction as stock markets too. A short-term negative correlation with stock prices would be normal: rising equity indices, a sign of happy investors, tend to align with compressing spreads and viceversa. Positive correlation would also be unusual here, as rising stocks (positive sentiment) would not normally match credit spreads selling-off (negative sentiment) unless technical factors such as changes in the bond demand and supply are taking place. A stronger correlation with stocks, instead of yields, is a possible indication that credit spreads are currently following investors' sentiment more than macro dynamics.