Chart of the Week

CREDIT MARKETS LOOK MORE EXPENSIVE THAN EQUITIES

Like most risk assets, corporate bond markets have performed well this year. At the time of writing, the iBoxx USD High Yield index is up around 8% in dollar terms (source: Bloomberg).

The primary drivers of corporate bond returns are interest rate (duration) risk and the credit spread. The latter represents the additional yield an investor demands over an equivalent-dated government bond to compensate for the possibility of the corporate borrower defaulting.

The duration risk is determined by how the underlying government bond yields are faring.

After their recent ascent, longer-dated Treasury yields are now trading slightly higher for the year-to-date, leaving their total return around flat. This means duration risk has made a negligible contribution to the broader credit market gains.

Which leaves tightening credit spreads as the principal driver of that 8% total return.

Aggregate high-yield credit spreads have fallen from almost 4% at the start of the year to just below 3% now, suggesting investors are becoming less concerned about default risk.

Even the riskiest parts of credit markets have seen spreads compress, despite slowing economic growth and pockets of corporate distress. The chart below shows the yield premium for issues rated CCC or lower has fallen from 10% to less than 8% this year.

Given the supportive policy backdrop, the risk of a major credit event appears relatively low, but these historically low spreads indicate a high degree of investor complacency and we believe there may be a better entry point for buying longer-dated, lower quality credit issues.