Tuesday, June 28, 2022
Fixed income’s negative returns have been historic so far in 2022, with the U.S. Aggregate index down roughly 11%. No fixed income sector has been immune to hot inflation prints and rising rates (e.g., 10-year Treasury yield has doubled YTD) as the Federal Reserve quickly shifted to monetary tightening. While the rates market has been historically volatile in 2022, what about the credit markets? Even with double digit negative returns, is there a case to be made that fixed income credit sectors have been resilient during the equity bear market of 2022?
A common metric used to monitor credit markets is option-adjusted spread (OAS), which is the additional yield or compensation investors require for taking on additional risk relative to Treasury securities. Looking at spreads during previous equity bear markets since 2000, how have credit spreads (as measured by the ICE BofA High Yield Index) behaved? As shown in the LPL Chart of the Day, investors unsurprisingly require additional yield when equities decline meaningfully. For example, the equity bear market from March 2000 to October 2002 saw high yield spreads peak at over 1100 bps (11%). In the six equity bear markets since 2000, the median peak in spreads is nearly 1000 bps. So far in 2022, high yield spreads have peaked at 538 bps as of 6/23. This indicates that credit has been resilient relative to previous equity bear markets, and roughly in line with the near bear market of 2018. While high yield has returned negative 13% so far in 2022, this poor performance has been primarily driven by a rise in rates, not market participants broadly expecting deteriorations in credit quality and a sharp rise in defaults for high yield bond issuers.
What might explain this resilience in credit in 2022? Post the Great Financial Crisis, the high yield bond landscape has improved in credit quality. As of 2007, 36% of broad high yield indices were rated BB, one step below investment grade. By the end of 2021, BB-rated high yield bonds represented 53% of the index. Additionally, the COVID-19 pandemic in 2020 resulted in a rise in defaults, peaking at 9%. Removing these bonds from the index left the index in a stronger position to withstand future stress and market volatility. Lastly, the energy sector’s strength has bolstered the broader index. So far in 2022, domestic high yield energy bonds are outperforming the index by approximately 400 bps, with overall spreads for the sector peaking at ~440 bps YTD (versus 2500 bps in March 2020 and over 700 bps in 2018). While we expect spread levels to remain volatile in the near-term with potentially widening if the U.S. enters a recession, the sell-off in 2022 offers an attractive entry point for investors, especially those looking for income as broader high yield indices offer yields above 8%.
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