- Fixed Income Portfolio Manager
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Anyone who invests in or follows the US credit markets has likely heard some version of the phrase "credit spreads are exceedingly tight" repeatedly in the past year.
What does this mean? When credit spreads are tight, it’s important to evaluate the level of compensation received for lending to a business versus the US government (as represented by US Treasuries), and how this pairs with one’s outlook for the economy and company fundamentals. Figure 1 illustrates the option-adjusted spread (OAS) of the Bloomberg US Corporate Bond Index, a proxy for US investment-grade fixed income, as a percentage of the yield-to-worst, or the lowest potential yield that an issuer can pay on a bond without defaulting, of the index. This demonstrates the relative compensation investors receive by choosing to allocate to this sector compared to US Treasuries — the higher the line is on the chart, the more compensation an investor receives for the additional risk.
Figure 1
Right now, the additional compensation for lending to investment-grade companies relative to the US government is at levels not seen since before the global financial crisis, in 2007.
For the past three years, we’ve believed US Treasury volatility would exceed the volatility of credit spreads in the US investment-grade corporate market — a dynamic that’s come to pass. However, a key difference between the environment three years ago and today is that in a period such as 2022, when the US Federal Reserve was raising interest rates in an effort to tame inflation, credit spreads were significantly wider to begin with, as concerns about a recession rose. At the time, the additional spread in corporate bonds compensated investors for volatility in US Treasuries because a rise in the Treasury base rate could be absorbed by credit spreads tightening. In today’s environment, unless we are about to enter a level of OAS as a percentage of yield not seen since before the year 2000, we believe there is little scope for credit-spread tightening broadly.
Against this backdrop, we suspect it may be difficult for fixed income managers who must seek to replicate and outperform a benchmark to navigate the market effectively, given the lack of additional premium for investing in corporate bonds. Flexibility to rotate between Treasuries and credit may be crucial to mitigate credit risk in the current environment. As such, we maintain our conviction that benchmark-agnostic fixed income managers who can adjust their allocations more freely may be better positioned to navigate the current market.
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