But Wait, There’s More! The Near-Term Outlook For Credit Markets

On a personal level for many, 2020 may have seemed like one endless nightmare of an infomercial. At least the memes in my social media feed would suggest as much. For credit markets, however, the returns just kept coming once the Fed stepped in with its strong policy support in late March. With strong returns in the fourth quarter, both investment grade and high yield corporate markets in the U.S. ended the year with positive returns over equivalent duration Treasuries.1 Notwithstanding the mild taper tantrum-like behavior we’ve seen in the last few weeks, corporate bonds spreads have rallied further still in early 2021. This ultimately begs the question for investors: can we really expect more from credit markets going forward?

Well, if history is any guide, then yes! There could still be more return juice to be squeezed out of credit markets. While valuations are certainly less compelling than the average, what investors often seem to forget in credit markets is how much sequencing really matters. Yes, spreads are low. But, how long have they been low is a very relevant question for the near-term return outlook. Credit markets typically take time to build up imbalances that lead to instability and ultimately collapse. Yes, exogenous events can occur to accelerate that process. We just had a big one! But, that is the exception rather than the rule.

Corporate bond performance amid tightening spreads: What history tells us

Let’s dive into that history just to prove the point. Using data back to 1989, U.S. investment-grade corporate bonds spreads2 have, after a sustained period3 above 100 basis points, broken below that level five times as they just did in December. The average return over the next 12 months for the sector was 5.9%. In three of those five instances the spread was still below 100 basis points a year later and in only one instance did the sector produce a negative total return.

Similarly, we can look at the U.S. high yield bond market,4 this time using 325 basis points of spread as our key level—a level the market just broke through in February. Here, we also find five instances dating back to the 1994 start date for such data, but this time in all five instances the total return over the subsequent 12 months was positive with, coincidentally, an average return of 5.9%. Spreads were less likely to be even lower than where they started in high yield, but then the carry is much higher to protect against total return losses.

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Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

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