Credit market shows confidence in the economy

At present, prices in the corporate bond market (credit market) reflect very little concern about the state of the economy. Spreads have been contracting significantly, even on paper from issuers with lower credit ratings. In the prevailing environment of low interest rates, demand for bonds that offer a risk premium should remain high.

The spread of the new coronavirus (Covid-19) in China and beyond has not curbed the risk appetite of investors so far. Quite the opposite: It seems that nearly all economic risks have been priced out. This applies to many asset classes, including the credit segment. Spreads are clearly narrowing, both on investment-grade paper and on high-yield bonds. In addition, spreads are converging across assets from issuers with different credit Ratings.

For example, calculations by Morgan Stanley show that the average spread between the 25 issuers with the highest risk premiums and the 25 issuers with the lowest risk premiums has narrowed substantially since the start of the year. The spread dispersion across issuers with weaker credit ratings has also reduced relative to that of higher-quality issuers. This means that relative historical credit risk only plays a minor role as a differentiating factor in the market at present. Investors must therefore be assuming that default rates among the weakest issuers will remain low.

Picture has changed since December

The picture looked quite different as recently as December, when the same spread (difference between the highest and lowest average risk premiums) was much wider in the market’s pricing. The high level of dispersion was also influenced to some extent by high-profile outliers such as Thomas Cook.

But what does the downward trend in spread dispersion tell us? Dispersion is strongly correlated with the market’s assessment of the economy. Risk premiums on paper from issuers with lower credit ratings and cyclically sensitive issuers were driven up significantly in relative terms by concerns about economic growth in 2015/16 and again in connection with the trade dispute from 2018 onwards. On the other hand, converging spreads across issuers with very different credit ratings indicate that risks in connection with changes in economic conditions are perceived to be low.

The wider market is reflecting the same trend. In the five-year maturity band, the iTraxx Crossover index, which comprises the 75 most liquid issuers (mostly from the sub-investment-grade segment), reached a high for the year on 13 February 2020 and came close to its all-time high of 207.11 points (recorded on 12 September 2019). The iTraxx Main index, which comprises 125 highly liquid European investment-grade issuers, even climbed to a new record level. Overall, the credit markets have thus more than recovered the ground they lost in January as a result of the coronavirus.

CDS Indices reach highs

CDS Indices reach highs
* Right-hand axis. Sources: Markit/Refinitiv; as at 17 February 2020.

Some signs of weakness in the high-yield market

However, first signs of weakness have started to emerge. Weaker issuers in the high-yield segment, e.g. from the automotive supply sector, suffered disproportionately high price losses. By contrast, bonds from issuers with higher credit ratings and less cyclically sensitive business models held fairly steady.

Is the market positioned too bullishly? It remains unclear whether the coronavirus epidemic can be contained effectively. In the first place, the suffering caused by the disease is – of course – a humanitarian tragedy. But a wider spread would also have economic implications. Economic growth in China could take another hit in the second quarter if large parts of the Chinese economy become affected. The global fallout is hard to quantify. But it seems likely that pent-up demand will trigger rallies in the market sooner or later. As a result, the scope for potential harm to global economic growth should be limited.

Demand for paper offering risk premiums in the current low-interest-rate environment should remain high at any rate.

 

As at 17 January 2020