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Understanding spreads between corporate, high yield and sovereigns

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Understanding current trends in income

Understanding spreads between corporate, high yield and sovereigns

The industry has been predicting the end of the 35-year bond bull market for some time now.

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.”