A strange calm in credit
Corporate bond markets remain remarkably relaxed, with yields that offer little compensation for risks
Investors are nervous. There are few other ways to read the latest gains in gold – above $3,650 per ounce for the first time this week – or the big moves in long-dated government bonds. Yet some markets look remarkably unperturbed.
Take credit spreads – the gap between the yield on government bonds and corporate debt – which tend to blow out at times of stress.
Spreads for US investment-grade bonds are instead at their tightest since 1998, barely 0.8 percentage points (pp) above the yield on comparable Treasuries. Eurozone investment grade bonds are similar; they have been tighter at times (eg, 2007 and 2018), but remain very low. Spreads for non-investment grade bonds (known as high-yield) are around 2.9pp, a bit higher than they were earlier this year in both the US and European markets. But they are still right at the bottom of their long-term range, and below the 4%-plus area they hit in April – which was not itself exceptionally high.
MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
The growth of private credit
One theory holds that spreads are tight because government bonds are getting riskier and no longer offer a real “risk-free rate” to benchmark corporate bonds against. Some argue that top-grade corporate credit could trade on lower yields than governments (the spread on US AAA-rated bonds is around 0.3pp).
This feels like a stretch. The most likely escape route for governments is to have central banks buy bonds at low yields – a precedent set under quantitative easing. That is probably inflationary and inflation will hurt low-yield corporate bonds. If you expect this, you should demand higher yields, not settle for less.
Another argument with high yield, in particular, is that the corporate bond universe is of higher quality now. The growth of private credit – the hottest area in alternative assets over the past few years – means that lower-quality borrowers have migrated there to get more favourable terms. That has left the better borrowers in bonds. There is probably some truth in this, but spreads still look so tight that they don’t provide much compensation for risk.
Of course, tight spreads also explain why higher yields in private credit have proved so attractive. The challenge with private credit is that it is by definition less public, so it’s harder to have a clear picture of the market and how much risk investors are taking to earn, say, 200pp more yield from something much less liquid.
On the face of it, default rates remain low – around 1% according to a recent paper by ratings agency S&P Global. But this relies on a narrow definition of default and ignores selective defaults, such as converting cash interest into more debt, repayment holidays or extending debt maturities. Include those and defaults have been much higher, says S&P, despite the benign environment. Data from other analysts paints a similar picture. One has to figure there will be a reckoning here when the cycle turns, making low credit spreads in bonds a dangerous reason to reach further for higher yields in private credit.
This article was first published in MoneyWeek's magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
Get the latest financial news, insights and expert analysis from our award-winning MoneyWeek team, to help you understand what really matters when it comes to your finances.
Cris Sholto Heaton is an investment analyst and writer who has been contributing to MoneyWeek since 2006 and was managing editor of the magazine between 2016 and 2018. He is especially interested in international investing, believing many investors still focus too much on their home markets and that it pays to take advantage of all the opportunities the world offers. He often writes about Asian equities, international income and global asset allocation.
Cris began his career in financial services consultancy at PwC and Lane Clark & Peacock, before an abrupt change of direction into oil, gas and energy at Petroleum Economist and Platts and subsequently into investment research and writing. In addition to his articles for MoneyWeek, he also works with a number of asset managers, consultancies and financial information providers.
He holds the Chartered Financial Analyst designation and the Investment Management Certificate, as well as degrees in finance and mathematics. He has also studied acting, film-making and photography, and strongly suspects that an awareness of what makes a compelling story is just as important for understanding markets as any amount of qualifications.
-
UK house price growth slows amid Budget uncertaintyAnnual house prices dropped in London while rising by only 0.1% month-on-month
-
Do I need landlord insurance?Buy-to-let landlords need more than standard home insurance to protect their property. What is landlord insurance and how much does it cost?
-
Albert Einstein's first violin sells for £860,000 at auctionAlbert Einstein left his first violin behind as he escaped Nazi Germany. Last week, it became the most expensive instrument not owned by a concert violinist
-
Who is Rob Granieri, the mysterious billionaire leader of Jane Street?Profits at Jane Street have exploded, throwing billionaire Rob Granieri into the limelight. But it’s not just the firm’s success that is prompting scrutiny
-
Emerging markets boast top-quality growth stocks at bargain pricesOpinion Lim Wen Loong, investment director at Ashoka WhiteOak Capital, selects three growth stocks where he’d put his money
-
Beware the bubble in bitcoin treasury companiesBitcoin treasury companies are no longer coining it. Short this one, says Matthew Partridge
-
Klarna leads a financial revolution – should investors buy?Klarna has ambitions to rewire the global payments system and has huge growth potential
-
New faces don’t solve old problems – why strategy also matters when it comes to investment trustsOpinion Changing managers often fails to boost a trust’s performance, says Max King
-
How to profit from silver’s record riseSilver often lets investors down, but there may now be room for further gains, says Dominic Frisby
-
Are venture-capital trusts worth investing in?Venture-capital trusts are a tax-efficient way to invest in early-stage companies. But are they worth the risk?
