A bull market could bring historic tight credit spreads, bankers say

4 min read
Americas, EMEA
William Hoffman

US high-grade spreads have the potential to ratchet in to historic tights next year if the economy is able to rebound from the pandemic, according to several bankers.

The most bullish cases from banks have average high-grade spreads tightening into the 70s area, which would be tight the lows seen in 2006, according to ICE BofA data.

For example, BNP's bull case shows average high-grade credit spreads tightening 35bp on the year to 75bp over Treasuries, while Morgan Stanley's bull case is to 80bp over.

Even some base-case scenarios expect spreads to tighten inside of the 90bp context, which is the post-financial crisis low set in February 2018, ICE BofA data shows.

"There is an acknowledgement that there is potential for the market to go through [those post crisis tights]," said Jason Shoup, head of global credit strategy at Legal & General Investment Management America.

"That’s only 15bp-20bp away and it’s sort of remarkable to even be contemplating that given the year we just had given that GDP is significantly below what it was and that leverage has only gotten higher in corporate America as a result of the pandemic."

There are three things driving the move tighter in spreads, Shoup said. One, the high grade index is made up of higher quality credits as Single A and higher companies flooded the market this year in a play for liquidity at the same time that challenged Triple B credits fell to high-yield.

Two, technicals remain very strong and in a world of negative yielding debt, US corporate credit will look increasingly appealing to foreign investors if and when US Treasury rates begin to rise.

Finally, investors know that the Federal Reserve has a new tool in its back pocket for supporting corporate credit, which was not the case during the last credit cycle.

"There is absolutely an ability for this market to overshoot and reach the tights of the last cycle and maybe even go through them," Shoup said. "The question is how long does that last and does it last through the entirety of next year."

The Bears

A snapshot of Monday's market is a perfect example of the risks the market still faces.

The Dow Jones opened this morning down 500 points on news of a new strain of Covid-19 in the UK that spread more easily, threatening the economic recovery story.

In reaction, the 10-year Treasury rate – which has been climbing in recent weeks – dropped to 0.93% from 0.95% at the prior close.

"We’re still at least six months away from normalcy and I don’t find our asset class rich," said Tom Murphy, head of IG credit at Columbia Threadneedle.

Research firm CreditSights expects spreads to stay range bound near where they are trading now at 107bp over Treasuries or to even test new tights throughout the year, but by year end believes widening will take over.

"We view valuations as essentially priced to perfection and already pricing in a done deal on more stimulus, the success of a vaccine and a return to normal in terms of economic activity," CreditSights wrote in a report.

"This leaves little room for IG investors to withstand a policy misstep or a COVID hiccup in 2021. Our excess return target is +/- 1% with spreads ending the year in the 120bp-130bp range, as investors look for better value and higher yields elsewhere."