Tight credit spreads: should you be worried?

Recent surveys by CFA UK and Bank of America Merrill Lynch (BAML) highlight a growing nervousness among investors about the impact of further Fed rate hikes on fixed income assets. Possible historical precedents discussed are the bond market sell-off of 1994 and the spread rally during the 2004 hiking cycle. The 1994 scenario is obviously the more concerning and the BAML survey notes that 39% of respondents are indeed worried about wider spreads (compared with 26% expecting further tightening and 35% anticipating no change). According to CFA UK’s Valuation Index, the number of those considering corporate debt overvalued is even higher at 82%.

So, should you be concerned about a 1994-style bond market crash? We don’t think so, for a number of reasons.

First, the Fed has already started hiking rates. In 1994, a lot of the sell-off was owed to the fact that markets were surprised by the central bank’s action. In the current cycle, Fed officials did carefully prepare markets for both interest rate moves so far and have kept doing so since. In fact, when interest rate futures markets were pricing in four more rate hikes for 2017 after March 17, Janet Yellen took the floor and told them openly that they were too bullish.

Second, government bond yields had already risen substantially during the Trump rally in November last year, weeks ahead of the first Fed hike on December 14. This is similar to the behaviour in 2004 when Treasury yields had started to go up more than two months before Alan Greenspan announced the actual rate decision. Again, the Fed had prepared markets well. In the current cycle, the 10-year Treasury rate peaked around 2.60% in the days after the December hike and has since moved mostly sideways in a 40-basis point range. Most of the downward movements were triggered by geopolitical events (e.g. the US missile strike on Syria in April or more recently concerns about a possible Trump impeachment), while the upside seems to be limited as expectations of an economic recovery and rising inflation are mostly priced in. Thus, the risks for government bond rates are more skewed to the downside in our opinion.

Third, even if sovereign yields were to rise, their usually negative correlation with credit spreads means that corporates can be expected to outperform Treasuries (provided the relationship holds, of course), which is indeed what we have been experiencing since the US election in November.

So, if you are concerned about a bond market sell-off à la 1994 and are not prepared to forgo fixed income altogether, investing in shorter-dated corporate bonds seems sensible. Indeed, that segment of the market was the one that managed to deliver positive total returns even through the 1994-1995 cycle, as tighter spreads and coupon interest offset the impact of rising risk-free rates. However, in an environment of higher geopolitical risks and lower yields, government bonds may be the investment of choice.

We recently published a paper, in which we examine the above scenarios (and a few others) in much detail by stress testing a multi-asset class portfolio through both the actual historical market events and simulated pricing factor movements based on more recent correlations. The paper can be found here.

We will also hold a webinar on June 7, in which we present our findings from this study and for which you can register here.

Christoph Schon, CFA, CIPM

Christoph Schon is the Executive Director, Applied Research for EMEA at Axioma, where he generates insights into recent risk trends with a particular focus on fixed income and multi-asset class analysis. Christoph has been in the portfolio risk and performance analysis space for more than 10 years, having previously worked for Lehman Brothers/Barclays POINT and UBS Delta.