As we close out the summer of 2023, investment-grade (IG) corporate credit spreads have been extraordinarily resilient. The Bloomberg IG Corporate Index has traded in a very narrow range for many weeks now with the option-adjusted spread (OAS) at 118 basis points (bps) last Friday. Year-to-date tights were set at the end of July at 112 bps. We now head into the post-Labor Day period, which has historically experienced some of the most volatile markets on the calendar.
Today’s Chart of the Week shows the average 12-month forward excess returns for IG corporate credit for various OAS starting points. Excess return here represents the outperformance of IG corporate bonds over that of an equivalent duration Treasury security. This picture is somewhat gloomy with the current OAS inside +120 bps. As the chart highlights, with the OAS at 120 or tighter, excess returns have historically been negative for the following 12 months (underperforming Treasuries).
There are other reasons to take a cautious stance on corporate credit as well. The inverted Treasury curve remains. While the 3-month Treasury bill to 10-year Treasury curve is off of its most inverted point of -186 bps in May of this year, it still sits at -124 bps and is at a level never witnessed prior to this inversion. On Friday in Jackson Hole, Federal Reserve (Fed) Chair Jerome Powell reiterated the goal of a 2% inflation target and below-trend growth. He continued, “we are attentive to signs that the economy may not be cooling as expected…Additional evidence of persistently above-trend growth could put further progress on inflation at risk and could warrant further tightening of monetary policy."1
To this point, the consumer has been rather resilient; however, cracks appear to be forming. Consumer debts are increasing, savings are falling and delinquencies are increasing. Macy's and Dick’s Sporting Goods have expressed a cautious consumer outlook while Nordstrom has seen delinquencies rise above pre-pandemic levels, which could result in higher credit losses in the months ahead.
Somewhat offsetting these pressures, the move higher in yields has been quite impressive and has led to yield buyers stepping in and limiting any meaningful backup in spreads. The yield on the Bloomberg IG Corporate Index was over 5.75% last Friday. While this is below the 6.125% yield last October, it was last at this level during the Global Financial Crisis. Overseas demand for U.S. corporate credit remains strong as well. According to Citigroup, foreign investor participation relative to total net supply has increased to over 50% this year, stronger than in prior years. Over the 2016-2022 period, foreign demand accounted for 39% of net supply.
Key Takeaway
I expect a fairly volatile post-Labor Day period along with a somewhat active new issue calendar. Although the narrative for a soft landing has gained traction, it should not be confused with a cyclical recovery. The economy is still slowing meaningfully, and the consumer is increasingly feeling pressure. At current valuations, it seems wise to stay up in quality in corporate credit, as forward excess returns from these spread levels have historically been quite disappointing.
Sources:
1Board of Governors of the Federal Reserve System – Inflation: Progress and the Path Ahead; 8/25/23
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