What to Watch When Credit Spreads Narrow

Credit spreads are at the lowest levels in more than two decades, indicating health of the corporate sector. However, our Head of Corporate Credit Research Andrew Sheets highlights two forces investors should monitor moving forward.

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Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Head of Corporate Credit Research at Morgan Stanley.

Today – what to make of credit spreads as they hit some of their lowest levels in over 20 years? And what could change that?

It's Friday, August 22nd at 2pm in London.

The credit spread is the difference between the higher yield an investor gets for lending to a company relative to the government. This difference in yield is a reflection of perceived differences in risk. And bond investors spend a lot of time thinking, debating, and trading what they think it should be.

It increases as the rating of a company falls and usually increases for bonds with longer maturities relative to shorter ones. The reason one invests in credit is to hopefully pick up some extra yield relative to buying a government bond and do so without taking too much additional risk.

The challenge today is that these spreads are very low – or tight, in market parlance. In the U.S. corporate bonds with Investment Grade ratings only pay about three-quarters of a percent more than U.S. government bonds of the same maturity. It's a similar difference between the yield on companies in Europe and the yield on German debt, the safest benchmark in Europe.

And so, in the U.S. these are the lowest spread levels since 1998, and in Europe, they're the lowest levels since 2007. The relevant question would seem to be, well, what changes this?

One way of thinking about valuations in investing – and spreads are certainly a measure of valuation – is whether levels are so extreme that there's not really any precedent for them being sustained for an extended period of time. But for credit, this is a tricky argument. Spreads have been lower than their current levels. They were that way in the mid 1990s in the U.S., and they were that way in the mid 2000s in Europe, and they stayed that way for several years. And if we go back even further in time to the 1950s? Well, it looks like U.S. spreads were lower still.

Another way to think about risk premiums – and spreads are also certainly a measure of risk premium – is: does it compensate you for the extra risk? And again, even with spreads quite low, this is tricky. Only making an extra three-quarters of a percent to invest in corporate bonds feels like a pretty miserly amount to both the casual observer and yours truly, a seasoned credit professional. But when we run the numbers, the extra losses that you've actually experienced for investing in Investment Grade bonds over time relative to governments, it's actually been about half of that. And that holds up over a relatively long period of time.

And so, while spreads are very low by historical standards, extreme valuations don't always correct quickly. They often need another force to impact them. With credit currently benefiting from strong investor demand, good overall yields, and a better borrowing trajectory than governments, we'd be watching two dynamics for this to change.

First weaker growth than we have at the moment would argue strongly that the risk premium and corporate debt needs to be higher. While the levels have varied, credit spreads have always been significantly wider than current levels in a U.S. recession; and that's looking out over a century of data. And so, if the odds of a recession were to go up, credit, we think, would have to take notice.

Second, the fiscal trajectory for governments is currently worse than corporates, which argues for a tighter than normal corporate spread. And the recent U.S. budget bill only further reinforced this by increasing long-term borrowing for the U.S. government, while extending corporate tax cuts to the private sector. But the risk would be that companies start to take these benefits and throw caution to the wind and start to borrow more again – to invest or buy other companies.

We haven't seen this type of animal spirit yet. But history would suggest that if growth holds up, it's usually just a matter of time.

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