JP’s Journal: Let’s talk credit spreads

One question that I get asked a lot at the moment is that if I expect recessions in many of the leading economies, why am I positive on credit?

This question came up at my weekly meeting with Distribution colleagues (courtesy of John Parkin): why would investors consider adding to credit bonds when the outlook is so uncertain? The answer is simple in my opinion: valuations are attractive. It is a striking feature of credit markets that valuations are not really considered in the same way as they are (were) for equities. There seems to be more directional evaluation: reduce relative credit risk if economies are likely to deteriorate and increase when things are improving. It still surprises me how many credit strategists, in their forward-looking projections, fail to consider starting valuations. It seems to be based upon an assumption that market pricing is correct and the skill is then in calling the next macro move.

There is something innately pessimistic about bond managers. We are a miserable lot really. Analysing the downside, looking for pitfalls and seeing the world through a 'glass half empty' lens. The most successful managers – and I would mention my colleague Eric Holt here – use this psychological bias to their advantage. Yes, look for the traps but seize buying opportunities when others overact to bad news, rating downgrades etc. The herd instinct is alive and flourishing in bond markets and is one reason why I believe the best active credit managers, standing back from the noise, can outperform benchmarks over the longer term.

This general pessimistic bias also can be seen at the asset class level. I remember reading, many years ago, an article about credit bonds. As a newbie it did not seem to make intuitive sense. Investment grade credit was both higher returning and lower risk than gilts. Surely that couldn’t be right? Credit bonds can and do default; UK government debt will not, therefore, credit is inherently riskier? Plausible, but wrong. Wrong if we equate risk and volatility. Over longer holding periods, the excess yield (spread premium) available from credit bonds both delivers higher returns and lower annualised volatility. Another way is to say that investors are consistently overcompensated for default risk. There is a caveat here. The likelihood of outperforming has historically been higher the longer the holding period. There are few ten-year periods in the last hundred years where credit returns have lagged government bonds. Nevertheless, pessimism tends to distort managers’ views. Will it be a good or bad year for relative credit returns? Whilst the choice is binary (out or underperformance) the chance of either occurrence is not symmetrical. The statistics really favour credit.

But, of course, this is dependent upon the starting valuation point. So where are we now? Non-gilt sterling investment grade credit indices closed last week with a spread of around 1.6%. Using historical analysis, the amount of excess spread required to compensate for past default rates is materially below 0.5%. Of course, future default rates may he higher – but I don’t see why given the economic and market turbulence reflected in the historic data. If we look at the spread widening that would be required to equalise gilt and credit returns, a move around 25bps wider would still see credit outperform gilts – just. But in my view, RLAM sterling credit strategies offer a further material advantage over credit benchmarks. Our portfolios should be able to cope with even more spread widening. We are taking more risk – but it is calculated risk based upon our established investment philosophy. This is no guarantee of outperforming government bonds – but I believe the starting point is attractive for investors that can focus on the medium term.

US non-farm payrolls were reasonably upbeat in December and the unemployment rate fell to 3.5%. However, pay growth was weaker than expected with the yearly measure hitting 4.6% – now at its lowest since August 2021. Overall, the US labour market still remains tight, and I think that a Federal Funds rate move to 5% looks likely despite the better pay data.

Bond markets were generally on the rise last week. US 10-year yields moved down to below 3.6%, a drop of 30bps. Elsewhere, German yields slipped towards 2.2% and UK 10-year hit 3.5%, compared with 3.7% at year-end. Real yields moved lower – but not as much, giving rise to a fall in implied inflation in major markets. Looking at the UK, 30-year inflation is priced around 3.3%. This still looks a bit high but is a long way back from the near 4% reached in September 2022.

High yield spreads continued to contract last week, taking my favoured measure down by 20bps and to the lowest level in over six months. Sterling investment grade gains were much more modest and spreads remain above August lows. My preference remains for investment grade bonds over both high yield and government bonds, with duration positioned below benchmarks.

Skiers may be unhappy but the mild winter, so far, is reducing pressure on households and governments. A cold snap can quickly reverse this – let’s just hope it remains mild. From a personal perspective, Santa gave me heated gloves for my bike ride into work. So I am prepared.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.