But wait, there’s more! The near-term outlook for credit markets
On a personal level for many, 2020 may have seemed like one endless nightmare of an infomercial. At least the memes in my social media feed would suggest as much. For credit markets, however, the returns just kept coming once the U.S. Federal Reserve (the Fed) stepped in with its strong policy support in late March 2020. With strong returns in the fourth quarter, both investment grade and high yield corporate markets in the U.S. ended the year with positive returns over U.S. Treasury bills with the same duration.1 Not withstanding the mild taper tantrum–like behavior we’ve seen in the last few weeks, corporate bond spreads2 have rallied further still in early 2021. This ultimately begs the question for investors: can we really expect more from credit markets going forward?
Well, if history is any guide, then yes! There could still be more return juice to be squeezed out of credit markets. While valuations are certainly less compelling than the average, what investors often seem to forget in credit markets is how much sequencing really matters. Yes, spreads are low. But, how long have they been low is a very relevant question for the near–term return outlook. Credit markets typically take time to build up imbalances that lead to instability and ultimately collapse. Yes, exogenous events can occur to accelerate that process. We just had a big one! But, that is the exception rather than the rule.
Corporate bond performance amid tightening spreads: What history tells us
Let’s dive into that history just to prove the point. Using data back to 1989, U.S. investment grade corporate bond spreads3 have, after a sustained period above 100 basis points (six months in this analysis), broken below that level five times as they just did in December 2020. The average return over the next 12 months for the sector was 5.9%. In three of those five instances the spread was still below 100 basis points a year later and in only one instance did the sector produce a negative total return.
Similarly, we can look at the U.S. high yield bond market,4 this time using 325 basis points of spread as our key level—a level the market just broke through in February. Here, we also find five instances dating back to the 1994 start date for such data, but this time in all five instances the total return over the subsequent 12 months was positive with, coincidentally, an average return of 5.9%. Spreads were less likely to be even lower than where they started in high yield, but then the carry is much higher to protect against total return losses.
Canadian credit markets are highly correlated to those in the U.S. and we have observed a similar pattern here. Between October 31, 2002 and February 28, 2021, the correlation in spreads between the Bloomberg Canada Aggregate — Corporate Index and the Bloomberg US Corporate Index is 0.91. That means the moves in spreads between the two indices exhibit a very strong relationship.
(A result of 1 would mean that the spreads move in an identical manner).
The bottom line
It's that additional yield5 that many jumping out of the credit markets today may be forgetting about in a world where certain stocks and cryptocurrencies are making overnight millionaires with the magnitude of their price moves. That is certainly not the norm and there’s no guarantee, or even likelihood, that you as an investor are going to pick the right one that gets that immediate pop. It’s true the opportunity for major price appreciation in credit has likely passed. But that’s not end of story when it comes to returns in the credit markets. There’s more here on offer in these markets, and ultimately, we believe investors will be better served to keep calm and carry on.
1 The Bloomberg US Investment Grade and High Yield Corporate Bond Indexes returned 0.49% and 2.25%, respectively versus equivalent duration Treasuries in 2020. Duration is a measure which can be used to assess how sensitive a fixed income sector is to changes in interest rates.
2A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. Typically, it is calculated as the difference between the yield on a corporate bond and a government bond of similar maturity.
3 As proxied by the Bloomberg US Investment Grade Corporate Bond Index.
4 As proxied by the Bloomberg US High Yield Corporate Index
5 Yield is the income produced by an investment, such as interest or dividends. It is usually expressed as an annual percentage rate based on the investment’s cost or current market value.