Yesterday, the Federal Reserve (Fed) continued its restrictive policy and raised the federal funds rate by 25 basis points (bps). 1 In March 2022, the Fed embarked on this tighter path to squash record inflation with numerous 75 bp hikes. Fed Chair Jerome Powell yesterday indicated ongoing increases may be appropriate to be “sufficiently restrictive”. However, the market appears to continue to be pricing in a reversal of this policy well ahead of the Fed’s timeline.
With some positive surprises on the inflation front, credit spreads have proven rather resilient in the hopes of at least an imminent Fed pause (and/or rate cuts at the end of this year) as well as a soft landing for the economy. Spread optimism also has resulted from declines in other key risks, including the China “zero-COVID” policy and the European energy crisis.
The Bloomberg Corporate Bond Index closed last Friday with an option-adjusted spread (OAS) of 118, which is 18 bps inside the average spread since the global financial crisis (GFC) of 2007-08 and the tightest level in almost a year.2 During the post-GFC period, the tightest spreads (80 bps) occurred in the summer of 2021, a time when investors were pining for yield and negative-yielding debt globally grew to about $15 trillion.
However, other risks remain, including elevated interest-rate volatility and legitimate growth uncertainties. In addition, the Conference Board Leading Economic Index has fallen sharply to a level only seen in the last four recessionary periods.3 The yield inversion of the 10-year Treasury and 3-month Treasury Bills also set an all-time low a couple of weeks ago at -129 bps, eclipsing the previous record by more than 20 bps .4 Corporate earnings have produced mixed results while cautious outlooks have, in some cases, been accompanied by announced job cuts.
But investment-grade bond valuations seem to convey little possibility of even a modest downturn. This week’s Chart of the Week shows the investment-grade Bloomberg Corporate Bond Index OAS as a percentage of the index yield. Note that last Friday’s spreads hit a post-GFC low of less than 24% of the total yield.
Admittedly, there are supportive technicals at play here — yield buyers have often surfaced at wider levels and cash is increasingly being allocated to corporate credit. Although yields are off the recent highs, the Bloomberg Corporate Bond Index has not experienced yield levels in the current context during the post-GFC period.
While investment-grade corporate credit spreads are now 38 bps wide to the 2021 tights, the contribution of spread to the total index yield is at a post-GFC low. This leaves little room for material spread upside even if the Fed is able to orchestrate a soft landing. Technicals are currently supportive but numerous other indicators are flashing caution, and I expect spreads to face pressure into the second half of 2023.
1Source: Bloomberg- Key Takeaways From Fed Decision to Raise Rates a Quarter Point; 2/1/23
2Source: Bloomberg- Bloomberg Fixed Income Indices; as of 2/1/23
3Source: The Conference Board- The Conference Board Leading Economic Index® (LEI) Update; 2/1/23
4Source: CNBC- U.S. Treasurys; as of 2/1/23
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