Where Credit's Due
THU 26 MAY 2022
One of the troubling elements of the recent episode has been the sustained widening in credit spreads (the credit risk premium). Of course, high yield credit performance has always been correlated to equity and inversely correlated to liquidity and cross asset volatility or risk perceptions. As we have noted recently, there has been a notable shift in consensus beliefs from inflation fear to growth.
For credit, a key difference from prior episodes, is that central banks are tightening into a slowing growth environment. In addition, inflation has clearly been more pervasive relative to last two decades. On the positive side, corporate pricing power and profit margins are near record levels (in aggregate). On the negative side, the distribution of corporate leverage is skewed. Put differently, while the large S&P500 companies have record profit margins and low net debt/EBITDA, corporate debt relative to GDP (sales) for all companies (based on the national accounts profits) is still elevated relative to the credit risk premium (chart 1).
The big picture challenge, however, is that current profit margins and earnings are backward looking observations. As we noted earlier this week, all of the de-rating of equity so far has been driven by valuation multiple contraction. The earnings downgrade cycle still lies ahead judging by leading indicators such as the ISM index and the tightening in financial conditions. Historically the ISM (a proxy for growth, profits and cash flows) not surprisingly tends to coincide with wider credit spreads (the light blue line in the time series below is inverted so that a decline in growth correlates with wider risk premia – chart 2).
High yield credit spreads also tend to widen during phases of tighter financial conditions or when central banks hike rates and withdraw liquidity (chart 3). As we noted above, credit risk premia move inversely to liquidity and cross asset volatility. Stated differently, a long position in corporate credit is effectively a short volatility position.
If growth, profits and corporate cash flow (the capacity to repay debt) remain strong, spreads don’t necessarily widen during the early central bank tightening cycle phase or when policy remains accommodative relative to neutral. However, the challenge in this episode is that central banks are tightening into a slowing growth environment and that risk compensation in junk bonds is only back to the long term average (around 500 basis points). Historically, spreads tend to overshoot. In this region, high yield risk compensation is considerably greater. However, it is probably too early to take on high yield credit in the US and Europe.