What has happened to spreads over 2016-2017?

Since the start of 2016, credit spreads have reacted to the various elections in the UK, Europe and US, as well as to events in China and the commodity market.

Generally speaking, spreads have been tightening but understanding what has caused spreads to tighten or widen may help advisers and investors predict how they may perform in the future and where they should be positioned.

Ben Edwards, fixed income manager at BlackRock, suggests movements in credit spreads since the beginning of 2016 can be broadly divided into three phases:

• “Firstly, the sharp sell-off in January 2016 on oil and commodity related fears and the subsequent, and equally sharp, recovery as China shifted aggressively to an easier policy footing, allowing global deflationary concerns to ease.
• “Secondly, some moderate weakness in spreads, particularly those of UK banks, as investors sought shelter from the uncertainty of the June 2016 referendum, followed by a strong performance after the vote, with UK corporate bonds outperforming – aided by monetary policy support by the Bank of England. 
• “And lastly, 2017 has seen a robust start to the year, with a rotation away from bonds seemingly off the cards for another year, and a market-friendly outcome in the French election, allowing investment grade and high-yield spreads to move 10 per cent and 15 per cent tighter respectively.”

Identifying trends

Martin Horne, head of European high yield investments at Barings, goes back a little further to explain some of the trends in credit spreads.

He says: “Spread tightening in 2016 was really a function of the credit spread widening we saw in the latter halves of 2014 and 2015, respectively, the catalyst for which was the commodity cycle. 

“As we moved through the second quarter of 2016, spreads broadly returned to where they were at the start of 2014 against a backdrop of lower defaults and greater and more widespread economic resilience.”

Excluding the widening in the immediate aftermath of Brexit, the tightening in credit spreads has been relentless.Nicolas Trindade

The collapse in the oil price, and lower commodity prices in general, was the result of supply and demand issues, with an oversupply of oil driving down prices, which hit oil exporters particularly hard.

Many of those oil exporters are emerging markets countries, but there were also plenty of oil importers who benefited from the drop.

The oil price has since recovered to hover around the $50 per barrel mark but it has certainly not recovered to the highs seen around 2008 when oil was nearly $150 a barrel.

At the same time, there were concerns about China’s slowing economic growth in 2016, which also played out in credit spreads and contributed to their widening.

Nicolas Trindade, senior portfolio manager at AXA Investment Managers, observes: “Spreads have been significantly tightening since February last year, reversing the widening trend we saw from mid-2015 through to early 2016. 

“Spreads widened at the time in reaction to concerns around China’s growth and the subsequent sell-off in the commodities market. Excluding the widening in the immediate aftermath of Brexit, the tightening in credit spreads has been relentless.”

He believes the main cause of the ongoing tightening in spreads has been quantitative easing, “with both the European Central Bank and Bank of England driving yields lower and credit spreads tighter through their bond purchasing programmes”.

“This in turn has further pushed investors into riskier assets in their hunt for high yields,” he adds.

According to JPMorgan Asset Management’s unconstrained fixed income product specialist, Marika Dysenchuk, spreads tightened across sectors in 2016:

• US investment grade was about 40 basis points (bps) tighter.
• US high yield was about 250 bps tighter.
• Euro high yield was about 80 bps tighter.
• Emerging market debt sovereign was about 75 bps tighter.

Although credit spreads have been a little more volatile in the past 12 months, they have generally been trending lower.

Al Jalso, senior portfolio manager at Russell Investments, notes: “Volatility has been predominantly political – UK referendum on the EU, the US and French presidential elections, issues related to President Trump’s administration and policy progress.  

“The trend tighter in spreads has been driven by fundamentals (modestly positive growth in the US, UK doing reasonably well despite Brexit, and EU posting improving economic data, corporate credit quality) as well as the ongoing positive technical of investors searching for yield in a persistently low rate environment.”

More stable?

So where might credit spreads go from here?

Spreads have been coming in since last year and there are some who believe spreads are not quite as compelling as they were.

In general, credit spreads tend to be maintained throughout monetary policy hiking cycles and don’t widen until recessionary periods.Marika Dysenchuk

Ben Willis, head of research at Whitechurch Securities, observes: “Credit spreads have been relatively more stable in 2017 as the inflationary outlook has been checked by geopolitical concerns, not least President Trump, Brexit and European elections.

“However, areas of attractive spreads can be still be found in certain sweet spots.”

He picks out BBB-rated bonds as generally offering the best spreads in terms of risk/liquidity premia, “while financials spreads, particularly bank paper, have remained at wider levels due to their complexity”.

There are other pockets of value to be found in other areas of the credit market too.

Ms Dysenchuk suggests credit spreads will continue to grind tighter throughout the remainder of 2017 and should help to absorb any potential interest rate rises, although it will not be the same level of credit tightening investors are used to seeing.

“In general, credit spreads tend to be maintained throughout monetary policy hiking cycles and don’t widen until recessionary periods,” she says. 

“Given that tendency and the strong macro and corporate health backdrop (solid growth, positive earnings releases, declining leverage) we do not expect significant credit spread widening in the near to medium-term.” 

On what to look out for during the rest of 2017, Ms Dysenchuk points out: “One of the key drivers/supporters of the spread tightening over the past year has been supportive flows, particularly on the investment grade credit and emerging markets debt side.

“This will be a key factor to monitor going forward, as any turn in investor demand could remove a catalyst for tighter spreads.”

eleanor.duncan@ft.com