Credit Spreads In Review.

Move of the year, XOVER:

XOVER is 157 bps tighter year to date, the largest move in recent history bar the March 2020 COVID rally. Credit spreads have tightened as inflation has cooled over 2023, paving the way for rate cuts & a more benevolent outlook for leveraged issuers.

Another important factor compressing credit spreads has been the large decline in new HY issuance over 2022 & 2023 (2023 saw net outflows of ~€16bn from the €HY market). With coupons ~half of yields, issuers have been reluctant to come to market, with short supply putting upward pressure on HY bond prices. A skeptical eye would question if this pressure will unwind as the queue of issuers waiting to refinance unwinds if rates fall as expected in 2024.

USD:

A similar story is being told in the states, CDX HY has seen similar declines of 130bps YTD:

2023 rally is pressuring valuations:

HY spread Z scores have turned sharply negative and are currently at c.-2x. The FED spoke last week (mid December 2023), painting a rosier outlook on domestic inflation, and signaled towards rate cuts in 1Q24.

Markets reacted strongly, in the UK 0-5 year sovereigns tightened by ~20bps on the news, with similar moves observed across Eurozone sovereigns. While the BOE & ECB face a tougher outlook than the FED, a global landscape of falling rates & a steepening curve is taking shape.

Taken together, valuations have moved into “rich territory”. Despite this, falling rates are likely to support a hunt for yield & continued bid for credit.

USD:

IG vs HY:

However, IG has also seen spreads plummet. Zooming in on credit risk, XOVER (HY) credit spreads are currently ~5.3x credit spreads on the Itraxx Main (IG) vs a long term average of 4.75x.

On balance, HY currently offers historically favorably compensation for credit risk over IG:

USD:

Looking forwards:

The ECB is expected to cut rates in 2024. Despite compressed spreads (Z score of ~-2), lower rates could sustain the bid for credit in 2024, with a bull steepener taking shape as short-run rates (where monetary policy takes place) fall faster than long-run rates.

Swaps are currently pricing ~160bps of cuts across the Eurzone out to YE 2024:

In the US rates are expected to decline faster owing to a more benign outlook on domestic inflation (in part due to their relative isolation from the fallout of the Ukraine war on input costs). Unlike the Eurozone, the growth outlook is more benign in the US, should growth weaken sharply in the Eurozone we could see rates cut more quickly.

HY Credit Indices Data Table:

Credit has rallied across geographies YTD. Sterling HY indices delivered the strongest return at 15.26%, followed by USD (12.91%), and EUR (11.89%).

There was a fairly uniform move in credit spreads, with XOVER & CDX HY tighter by 157 bps & 130bps.