KBRA Financial Intelligence

3 Things in Credit: Compressed Spreads, Abundant Liquidity, and Texas Downdraft

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Welcome, market participants, to another 3 Things in Credit. I’m Van Hesser, Chief Strategist at KBRA. Each week we bring you 3 Things impacting credit markets that we think you should know about. It’s been a dizzying week of newsflow with FOMC, jobs, and Big Tech earnings. A lot of uncertainty has been cleared up. One last bit of news we’re waiting on—how many Olympic triathletes got sick from swimming in the Seine.

This week, our 3 Things are:

1. Spread compression. Does this make sense heading into slowdown?

2. Abundant liquidity. One asset manager says credit is overbought as a result. We’ll explore.

3. Texas downdraft. This caught us by surprise.

Alright, let’s dig a bit deeper.

Spread compression.

I don’t have to tell you that the monetary transition from massive quantitative easing from 2009 to 2021 to suddenly restrictive starting in 2022 has been a painful one for fixed income managers. And I don’t have to tell you that getting to the other side of that change, where yields today are the most attractive in 15 years, and where the 60/40 portfolio once again makes sense, has been a boon, of late, to the credit asset class.

With the rates part of the credit yield equation representing a historically disproportionate share of returns—call it 80% or so of investment grade and 60% of high yield—you have to wonder if markets have gotten complacent with regard to the credit portion.

Looking backward, the answer is clearly no. Against conventional wisdom (and history), we seemed to have achieved “immaculate disinflation.” The economy has been growing well above potential, unemployment has remained quite low, and corporate earnings have recovered nicely from the inflation shock. And inflation, of course, is moving convincingly toward target. All of that suggests that credit spreads should be tight and compressed at this point in the cycle.

And they are, both investment grade (IG) and high yield are well through long-term averages, as are rating category differentials: BBBs are just 33 bps wide of single-As (the long-term average is 58 bps), while high yield is just 215 bps wider than IG compared to its long-term average of 343 bps.

But now, we’re seemingly at an inflection point and the narrative is changing, from holding down inflation to slowdown, from higher for longer to rate cuts. This naturally begs the question, should your positioning change along with it?

The first consideration is, just how material is this change? We’ve made the case that it shouldn’t be all that dramatic. Within our “Two Economies” theme, we remind folks that the cohorts doing well—wealthier households and larger businesses—clearly are carrying the day in terms of the aggregate data. That’s where we get soft landing. So much in the credit risk opportunity set still makes sense from a fundamental standpoint.

Add to that two positive technical factors: (i) expected rate cuts, which will be unusually meaningful given the importance of rates in your returns; and (ii) reduced issuance expectations in 2H 2024. The latter takes into account record-setting issuance in 1H from treasurers trying to get ahead of election season volatility.

So, it makes sense for buy-and-hold investors to largely stay the course across the risk spectrum as all but the most vulnerable credits should be able to withstand “slowdown” as long as we avoid recession. On that point, to the extent you believe in the wisdom of crowds, we remind listeners that one-year recession probabilities stand at or around 30% in both Bloomberg and The Wall Street Journal surveys. For active managers, this is an opportune time to selectively move up in quality, selectively reducing riskier and more cyclical names and sectors.

Alright, on to our second Thing—Abundant liquidity.

In Oaktree’s Performing Credit Quarterly for Q2 2024, there is a meaningful amount of attention paid to liquidity. More specifically, how abundant liquidity (stimulus-fueled) has put upward pressure on prices in most asset classes. The authors believe that the deployment of this concentration of wealth, found on the balance sheets of wealthy households and businesses, has caused capital markets to be far more generous than they otherwise would be in an elevated rate environment. As a result, says Oaktree, many highly-levered companies have been able to postpone potential problems by refinancing their debt into unsustainably or unjustifiably favorable financial conditions.

That’s quite a leap. Here’s how we think about it.

There is no disputing that there was a surge in liquidity during the pandemic. Pull up a chart of M2 on your Bloomberg and you’ll literally see the bubble, a 42% jump in the money supply from the beginning of the pandemic to April 2022. That money had to go somewhere. But did it all go into risk assets? The answer of course is no. It’s no great revelation that some of it went into Treasuries and some went to money markets (that’s the all-time high of $6 trillion you often hear referenced).

But we disagree with the implication that risk and reward have broken down, and that investors have overbought and overpaid for credit assets, simply because they could. If that were the case, you wouldn’t have record levels of very low-risk money market assets, or 10-Year Treasury yields through 2-Years. Riskier credit assets are well bid because the economy has performed much better than expected, which means recession risk is lower and that means lower default rates. Add to that the highest yields in 15 years courtesy of the rise in rates and you have strong demand.

And here’s the other important development. We’ve talked a lot about how the cost of capital has increased materially over the past two years in large part because the cost of debt has risen materially due to the Fed’s rate hikes. That means that achieving an acceptable rate of return has become, appropriately, more difficult. Accordingly, company business models and capital structures will be subject to greater scrutiny than has been the case for much of the past 15 years. And that is sure to usher in the return of capitalism’s creative destruction. To be fair, Oaktree ultimately gets around to this point: “We believe credit investors should proceed with caution and avoid assuming that major concerns about corporate credit are all in the rearview mirror.” On that, we would agree.

Alright, on to our third Thing—Texas downdraft.

We might very well be guilty of regional bias here, but those of us in the Northeast have long viewed Texas as a model of translating sensible economic policy into economic growth. So, we were more than a bit surprised this week with the latest regional update out of the Dallas Fed. Sure, we’re set to slow nationally, but after the Q2 GDP report where the growth rate doubled sequentially, we thought we’d see solid numbers out of the Lone Star State. We got that wrong.

The Texas Manufacturing Outlook Survey conducted by the Dallas Fed remains depressed. The data is collected monthly and diffusion indices (increases less decreases) are created across a number of factors.

Although manufacturing production levels have been holding relatively steady over the past couple of years, the outlook level of general business activity was negative (that’s where more survey participants cite “worsened” than “improved”) for the 27th consecutive month, the last 18 of which are double-digit negative. The outlook for the respondent’s particular company was negative for the 29th straight month. New orders dropped 12 points in the latest survey to a negative 12.8 signaling a renewed pullback in demand. Also, of note was just 12% of respondents reported raising prices in the most recent month, that’s down from near 50% back in the inflation rise period in 2021-22, and reflective of the fact that businesses are running into pushback from their customers on price hikes.

Texas looks like a leading indicator for what’s happening nationally based on this week’s ISM Manufacturing Survey, which came in well below already depressed expectations, reflecting softening demand.

A separate Dallas Fed survey for services isn’t much better, although optimism about the future is on the rise. The outlook for general business activity has been negative for 26 consecutive months, although the most recent result—virtually balanced between improved and worsened—was the best over that timeframe. Respondents’ expectations regarding future business activity jumped 16 points in July to a positive 19.1, its most optimistic since February 2022. Other future service sector activity indices such as employment and capital expenditures remained in positive territory and increased, reflecting expectations for growth in the next six months. Sounds like a few rate cuts are in order.

So, there you have it, 3 Things in Credit:

1. Spread compression. We’re not falling off a cliff, but the cost of moving up in quality is rarely this cheap.

2. Abundant liquidity. Just because you have a lot of money to put to work doesn’t mean all investing discipline is lost.

3. Texas downdraft. In manufacturing and in services, we’re seeing the bite of monetary tightening.

As always, thanks for joining. We’re kicking back next week on holiday, so look for our next 3 Things on Friday, August 16. We’ll see you then.