Are credit markets cheap?
The sell-off in global markets has been relentless and credit has been no exception.
Investors in corporate bonds and emerging market bonds are nursing losses after a sharp widening of credit spreads (the difference between their yields and the yield on a government bond of the same maturity).
The sharp widening in spreads means that investors are now being paid much more than previously to take on the risk of lending to companies. The result is that valuations have improved significantly and a lot of markets are now at extremely cheap levels.
Valuations have improved substantially
The table below highlights the extent of the cheapening. It compares the latest developed market investment grade (IG) corporate credit spreads (based on ICE BofAML credit indices) and the spreads of the IG portion of the JP Morgan emerging market sovereign (EMBI) and corporate (CEMBI) indices against the historical median spreads since 2002.
The figure also includes the same data as of 31 December 2019 for comparison. Figures are shaded dark red if they are more than 20% expensive compared with their 18-year average (median) and dark green if more than 20% cheap, with paler shades for those in between.
Clearly, the repricing has been extreme in recent weeks. At the end of last year, most IG index spreads were in expensive territory, 20-30% below the historical median. Sterling-denominated IG corporate bonds (GBP IG) was the best of a bad bunch in this respect.
As of 20 March, spreads have risen to almost double the historical median, or more than double in the case of USD IG. Emerging market corporate bond spreads are the least elevated, but even they are 68% above the median.
The table also shows the spreads of the high yield (HY) portions of the same markets. The overall picture is similar, with few differences. All the high yield markets in the developed world are trading on spreads that are close to double the historical median. As was the case with IG bonds, sovereign emerging market HY bonds are the cheapest on a historical basis. Similarly to IG, all the HY spreads were below the historical median in the beginning of the year.
How elevated are the spreads compared to the history? We can compare the current spreads against the historical distribution. For example, the USD IG spread has been higher in only 4% of the months since 2002 and the EMBI HY spread in only 1% of the months, highlighting the extreme levels.
However, it would of course be foolish to buy credit based on valuations alone. While credit spreads appear to offer far greater value than barely a few months ago, that does not mean that they could not widen further, exposing investors to losses.
Downside risks to spreads remain
Although credit spreads have widened, they are nowhere near the levels they reached at the height of the global financial crisis (GFC), as shown in Figure 2. To match those levels, they would have to increase by 60% to 170%. The exception is EMBI HY where the spread is now only 45bps short of the GFC peak. It is unclear if the current situation will match the severity of the financial crisis, an event that was supposed to occur only once in a life time.
Global central banks and governments have in recent days taken unprecedented steps to respond to the challenge posed by the coronavirus. These steps could provide significant support for credit, either through direct government support to companies, or through the purchases of bonds by the central banks.
Given the current state of things, this could be an opportunity for long-term investors, who can stomach large short-term volatility, to think more seriously about investing in credit. Investors with lower risk tolerance however, would be better off to wait for the dust to settle before making any significant moves.
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