Understanding spreads between corporate, high yield and sovereigns

As recent figures on net retail sales from the Investment Association (IA) confirm, investors are still turning to fixed income funds, perhaps recognising the need to de-risk in the current environment.

According to the IA’s statistics for January 2018, fixed income was the bestselling asset class, racking up £1.6bn in net retail sales.

At the time, equity markets were becoming slightly more volatile, after a couple of years of steadily climbing higher.

Chris Iggo, chief investment officer, fixed income at Axa Investment Managers, observed in February this year: “In the fixed income world, credit spreads have hardly budged during this period of increased equity volatility. 

“Since the beginning of the year, US high-yield spreads to Treasuries are actually lower and are only 20 basis points higher than the low reached last month.”

He notes it is the same story for investment grade credit indices, European high-yield and emerging market sovereigns and corporate bonds.

Wide or narrow?

What do fixed income managers mean when they refer to spreads?

Darius McDermott, managing director at FundCalibre, explains: “The spread is basically the difference between the risk-free rate – in the UK that will be gilts, in the US treasuries, for example – and what you are being paid over and above that to hold either investment grade bonds or high-yield bonds. 

“If the spread is wide, it means you are being well compensated for the extra risk (that the company defaults or doesn't pay its coupon). If they are narrow, it is debatable whether the risk is worth taking.”

Peter Elston, chief investment officer at Seneca Investment Managers, says spreads essentially relate to credit risk – the risk that the bond issuer will default. 

He notes: “The risk of sovereigns defaulting is negligible because governments can print money to repay debt – the risk then relates to inflation not default. 

“Indeed, some refer to inflation as ‘soft default’ as it wipes out the real value of future coupons and principle. 

“High-yield issuers are those which have low credit ratings and thus a higher risk of default – spreads are thus generally high. Investment grade corporates have high credit ratings and thus lower spreads.”

Where does this leave credit spreads now?

Distortions

Credit spreads have been tight for some time, meaning investors are not getting much in the way of reward for the risks associated with investing in these assets.

“The spread between corporate/high-yield bonds and the relevant sovereigns have been falling at the same time that sovereign bonds yields have hit historical lows,” observes Matthew Yeates, investment manager at Seven Investment Management. 

“There are many reasons for this and some would suggest it is demand for income that has driven those spreads lower. Given there are few other places to go in seeking a yield, investors have been snapping up these assets, driving spreads down and prices up.” 

He warns that whatever the reason, this behaviour has created distortions in bond markets that are difficult to understand.

“At present the yield, including the additional spread for lending to European high-yield (sometimes called junk bonds) companies for five years, is less than that available for lending to the US government for five years,” Mr Yeates adds.

Ultimately, we expect 2018 high-yield returns to approximate current yields, as spread tightening is offset by upward pressure on rates, and below-average defaults lead only to modest credit losses.Hannah Strasser

The interest rate environment also has an impact on spreads and where they are likely to go from here.

The recent appointment of Jerome Powell as chairman of the Federal Reserve, replacing Janet Yellen at the US central bank, has led many economists and analysts to believe the pace of rate hikes will increase this year to around four.

The latest economic data to come out of the US so far seems to support this.

The number of jobs added to the US economy in February was 313,000 – approximately 100,000 more than predicted.

But wage growth came down slightly in the month, to 2.6 per cent from 2.8 per cent and the unemployment rate remained flat at 4 per cent.

As a result, at its meeting on 21 March the Federal Reserve hiked interest rates from 1.5 per cent to 1.75 per cent.

Nancy Curtin, chief investment officer at Close Brothers Asset Management, confirms she still expects to see possibly another three to four interest rate hikes this year from the Fed.

"It was a fairly straightforward decision for [Jerome] Powell to take action and raise interest rates," she says. 

"The US economy seems to be in somewhat of a sweet spot, with a synchronised global economy, a weaker dollar, fiscal expansion and the prospect of increased business investment all supportive of growth.

"Wholesale tax reform should filter through more strongly into the economic data ahead, providing increased growth momentum. At the same time, inflation is showing signs of getting close to the Fed’s goal, and spare capacity in the labour market is declining.

“Mr Powell clearly sees this combination of a tighter labour market and ample supports to growth as reasons to embark on steady interest rate normalisation this year.

"He will be sensitive to signs of overheating and will keep a watchful eye on wage increases from here as a signal to tighten even further than the three to four times now expected by the market."

Rate risk

Interest rate risk is highly topical, confirms Hannah Strasser, managing director at Sky Harbor Capital Management, with the Fed on a clear path of rate hikes.

Generally speaking, faster-than-predicted rate rises will not be good for bonds.

“It is important to remember, however, that a rising rate environment is not necessarily detrimental to high-yield market spreads,” she points out. 

“While spreads on investment grade corporates, mortgage-backed securities and emerging market sovereigns tend to be positively correlated to government yields through the cycle, spreads on the high-yield index tend to tighten when government yields rise.”

She suggests: “Although the strength of this relationship varies over time, the inverse correlation likely reflects the idea that stronger economic conditions typically lead to higher Treasury yields and tighter spreads on risk assets, all else being equal. 

“We recognise, however, that this relationship tends to degrade at sufficiently tight spreads and, as such, requires thoughtful consideration when it comes to portfolio positioning.”

Ms Strasser thinks lower quality high-yield remains in a position to offset a rise in interest rates, in spite of material tightening over the past few months, although she acknowledges that higher quality high-yield is still susceptible to higher interest rates.

“Ultimately, we expect 2018 high-yield returns to approximate current yields, as spread tightening is offset by upward pressure on rates, and below-average defaults lead only to modest credit losses,” she concludes.

With so many investors piling into fixed income funds to help meet their income targets, managers will be keeping a close eye on spreads.

Anthony Rayner, co-manager of the Miton Cautious Monthly Income fund, expects spreads to start widening eventually.

He says: “Spreads between corporate, high-yield and sovereign bonds remain tight in a multi-year context, reflecting a positive environment for corporates and low sovereign interest rates. 

“Higher sovereign interest rates will likely put pressure on spreads to widen at some point.”

eleanor.duncan@ft.com