Bonding Experiences: Corporate Spreads, US/Italian Treasuries

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Bonding Experiences: Corporate Spreads, US/Italian Treasuries

Two items today:

Topic #1: The balances at the Federal Reserve’s Corporate Credit Facilities have barely budged in 3 months, so it’s a good time to see where marginally rated corporate bonds are “really” trading (i.e. in the absence of central bank intervention).

As a reminder: during the capital market dislocations earlier in 2020, Treasury funded special purpose vehicles at the Fed to allow the central bank to buy corporate bonds. There was a good reason for that intervention: investment grade spreads had blown out to +400 basis points over Treasuries, the worst levels since 2009. This market is critical to US banks – so much so that IG spreads are an item in the Fed’s annual stress tests – so the US central bank had to intervene by buying individual corporates and related bond ETFs. But over the last 90 days the balances in these facilities have been essentially flat ($45 bn as of last week, up less than $1 billion since early August). That means corporate bond prices should reflect market sentiment now, rather than levels artificially set by the Fed.

First up: BBB corporate bond spreads (in red) versus all investment grade (IG) corporates (in blue) over the last 12 months. We’re looking at BBBs since they are the marginal IG paper, just one rung above junk.

Two points here:

  • As you can see, neither BBB nor aggregate IG spreads are back to where they were pre-crisis. Friday’s 133/171 basis point spreads are well above December 31st, 2019’s levels of 100/129 bp. They’re getting closer, which is bullish of course.
  • Another positive: the difference between BBB spreads and all IG right now is 29% (171/133), right where it was at the end of last year (129/100). In other words, the incremental penalty just now for being a BBB corporate is no worse than it was last December.

Now, let’s move on and compare a lower rung of the investable high yield (HY) market – single B debt (in blue) – with HY spreads as a whole (in red) over the last year:

Two points here:

  • As with the previous data, single B and HY spreads are still above their year-end 2019 levels at 553 bp vs. 528 bp and 494 bp vs. 360 bp, respectively, but trending lower as hopes for a lasting economic recovery grows.
  • However, unlike the BBB/IG relationship, single B corporates are showing tighter spreads now (12 percent over HY) than at the end of last year (47 percent).

Takeaway (1): if there is one corporate bond market that is pricing in something of a “Fed put”, it is single B credits. These now trade much closer to generic HY spreads than historical averages (and not just 2019 year-end, but all the way back to the 1990s). At a third of the HY market (and ETFs like HYG), single B corporates are a large enough chunk to affect aggregate pricing. If you own high yield corporate debt, we’re in general agreement given our bullish outlook, but keep this in the back of your mind.

Takeaway (2): while corporate debt spreads over Treasuries reflect how this market prices risk, we should also spare a thought for the actual yield highly levered companies have to pay (chart below, BBB in red, single B in blue, 1997 – present). While the Financial Crisis creates a mountain right in the middle of this time series, there’s no missing the fact that BBB corporates on average pay just a 2.37 percent coupon and single Bs are at 5.5 percent just now. If one wonders why there are so many more lower-rated companies now than in the 1990s, this chart is a one-stop-shop with the answer.

Topic #2: While thinking through a comparison of US 10-year Treasury yields to those for Europe sovereigns, we realized that the closest comp to T-notes is actually Italian government debt.

Here is a chart back to the start of 2015 which shows this quite clearly: 10-year Treasury yields are in red, Italian 10-years are in green, and German/French yields are in black and blue, respectively.

The data here cuts out for the latest non-US yields, but today’s data holds to the chart’s long run record:

  • US 10-year Treasuries yield 77 basis points; Italian 10-years are at 72 basis points.
  • French and German 10-year yields are both negative, to the tune of -34 bp and -63 bp respectively.

We bring this up because European sovereign debt yields have fallen recently as public health concerns increase across the continent, and yet there is still a market narrative that expects Treasury yields to rise noticeably on the back of further fiscal stimulus. At the end of the day, rate markets are global, so we’re not convinced Treasury yields can increase quickly if Europe’s are declining. Our base case is a slow climb higher, at the most.