In the wake of continually elevated inflation readings, the lowest-ever University of Michigan Consumer Sentiment Index and another volatile ride in risk markets this week, the Federal Reserve (Fed) essentially acknowledged it is playing catch-up and raised its benchmark interest rate by 75 basis points (bps) yesterday. Rates have risen this week in anticipation, along with credit spreads.
As we approach the midpoint of the year, the broader market gyrations have been extraordinary. Certainly, the investment-grade (IG) corporate bond market has endured its share of pain. The total return for the Bloomberg IG Corporate Index is down an unprecedented 16.1% through June 14. The yield on this index started the year at 2.33% and has now more than doubled to almost 5.00%, while the option-adjusted spread (OAS) has widened from 92 bps to 141 bps.
This week’s chart highlights the significant move in yields for the IG Corporate Index to multi-year highs going back to 2010, and about 175 bps higher than the average over the period. Meanwhile, although spreads have widened, they remain close to the average since 2010. For corporate credit markets, the healthy balance sheet fundamentals at the end of 2021 have allowed spreads to be somewhat resilient through this initial phase of a rate-induced correction.
Company liquidity that was built up during the course of the pandemic had been a source of comfort to issuers and investors alike, although this appears to be turning. Decelerating earnings growth and increased instances of corporate cash being directed to buybacks, dividends as well as mergers and acquisitions are causing the trend in leverage to move higher. Lingering supply chain issues and higher input costs are also leading to greater margin pressures, while companies seek to manage inventories efficiently in an ever-challenging supply-demand balance.
The macro puzzle that credit markets are looking to solve has shifted from Fed rate increases and a healthy economy at the beginning of the year to concerns about entrenched inflation, rate hikes and consumer durability in a slowing economy. Further, from recent Fed governor commentary, it seems the Fed is more apt to respond to upside surprises in inflation than to downside surprises in growth.
Outside of a short period in 2018, aggressive Fed rate increases in a slowing economy have not been experienced by credit markets for decades. Credit spreads unsurprisingly have been rather volatile and have weakened given the inflationary data. But to this point, the spreads do not seem to adequately reflect the increasing possibility of a hard landing. This is not to say that a soft landing is impossible, but the road to the result should see enhanced concerns regarding growth more reflected in spreads.
The valuation proposition for owning duration risk has markedly improved from earlier this year with the sharp rise in yields. However, the risk associated with prolonged elevated inflation and slower growth does not appear to be fully priced into spreads. Whether the economy has seen peak inflation or not, inflationary impacts on company balance sheets are increasingly evident and the possibility of stressful demand destruction is increasing. I anticipate elevated episodes of volatility to remain commonplace for the remainder of the year, with corporate credit spreads experiencing instances of wider wides along the way.
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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.
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