Source: Bloomberg Source: Bloomberg

Year-to-date performance for financial markets has generally gone according to script. Rising equity prices led by value stocks and cyclicals, tighter credit spreads as well as higher Treasury rates and commodities prices are typical in an economic recovery. Similarly, within fixed-income markets, the high-yield and leveraged loan asset classes have outperformed on an absolute and excess return basis, while lower-quality and less duration-sensitive credit within high yield have performed best by a wide margin. In fact, CCC credit led BB credit by about 400 basis points (bps) in the first quarter, and the high beta energy and cyclical transportation sectors have outperformed defensive sectors by similar margins. While the direction of the moves was forecasted correctly by most, the speed of the recovery is the most notable dynamic.

The chart above shows the movement of high-yield spreads during the last few credit cycles, including the 1994, 2011 and 2015 spread-widening periods. In addition to the recessions of 2001 and 2008, the typical trough to peak (widest spreads to tightest spreads) has been about three years. Moreover, the beginning of spread-widening periods, even the one preceding the 2008 global financial crisis, can take a year or so to play out. The pandemic-driven widening event during 2020, by contrast, took place over one month. And the subsequent recovery, while not likely finished yet, has taken about a year. We have moved from the early to the late stage of the credit cycle very quickly. The current state of the market is such: CCCs have compressed to all-time tights, about 75% of the market trades below 5%, the level of distressed credit is de minimis and a very high percentage of the market trades north of par and is thus called constrained. As such, we are largely in a carry world. The good news is that default risk is dramatically reduced, earnings are improving and liquidity is readily available — you will have to work hard to find a credit blow-up in 2021.

Key Takeaway    

Absent a disorderly move higher in interest rates, I think high-yield spreads will remain below 400 bps for a few years, similar to the mid-1990s and mid-20o0s. While valuations aren’t particularly compelling, interest-rate risk appears more pressing than credit risk. Thus, a healthy allocation to lower-quality securities and the energy subsector will continue to be needed to achieve adequate carry. In the current environment, in which dispersion among managers may be increasingly narrow, a tennis analogy comes to mind — hold serve, keep the ball in play and attempt to hit winners when opportunities (volatility) emerge.

Tags: economic recovery | High yield | Interest rates | Credit risk | Credit spreads | Credit cycle | Treasury rates

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice.  The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete.  Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements.  Actual results may differ significantly.  Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.

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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.

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