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Charting the Market: Tight Credit Markets Complicate the Search for Income

  • As a result of the low rate environment and rally in risk assets, yields for different rating bands and broad exposures are all in the bottom 5th percentile
  • The difference in yield among credit rating bands has also never been smaller than it is now
  • While credit markets are tight, the environment is still conducive, but upside is more constrained for traditional fixed rate high yield
Head of SPDR Americas Research

Our current low rate environment has impacted all parts of the credit market complicating the search for income. Additionally, the yield difference among credit rating bands has never been tighter, indicating a lack of differentiation among segments.

Yet, because income generation is one of the three true outcomes of portfolio construction, alongside capital appreciation and risk management, it cannot be side-stepped because of scant opportunities.

In this charting market, I will discuss how investors on the hunt for income can navigate today’s anomalous fixed income market.

Extreme Low Yields for Credit

Credit has outperformed Treasuries year to date, as accommodative monetary policies, stimulative fiscal measures and resurgent growth have fueled a rally in risk assets. The strongest performance has come from the more speculative parts of the market, as shown below. There, duration headwinds have not been as big of a detractor as they have been in the investment- grade (IG) space. Duration has reduced broad IG returns by 5 percentage points versus 1.5 percentage points for broad high yield (HY).

Year-to-date Returns

Source: Bloomberg Finance, L.P. BofA Merrill Lynch, as of May 31, 2021. Broad high yield = ICE BoFA US High Yield Index, BB-Rated = ICE BoFA BB US High Yield Index, B-Rated = ICE BoFA B US High Yield Index, CCC & Lower = ICE BoFA CCC & Lower US High Yield Index = US IG Corporates and rating bands = ICE BoFA BB US Corporates Index. Treasuries = Bloomberg Barclays US Treasury Index. Past performance is not a guarantee of future results. Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in an index.

Combined with a low policy rate environment, these year-to-date gains have kept yields low. The yields on broad IG and HY US corporates are currently in the bottom 5th percentile over the past 20 years. And, as shown below, these low levels are supported by equally low yields among the credit ratings bands that comprise broad HY exposures – with only broad IG corporates escaping the bottom 1st percentile.

Current Credit Yield Profile

Source: Bloomberg Finance, L.P. BofA Merrill Lynch, as of May 31, 2021. Broad high yield = ICE BoFA US High Yield Index, BB-Rated = ICE BoFA BB US High Yield Index, B-Rated = ICE BoFA B US High Yield Index, CCC & Lower = ICE BoFA CCC & Lower US High Yield Index = US IG Corporates = ICE BoFA BB US Corporates Index Past performance is not a guarantee of future results. Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in an index.

Low yields for both broad and sub-rating segments shouldn’t be a big surprise, considering the rating band exposures make up the broader segments. However, there are two aspects that are surprising -- and anomalous. All the rating bands and broad exposures are:

1. At extremes (bottom 5th percentile)
2. In this range at the same time

This has never happened before, but it has now occurred for 113 consecutive days. If we were to raise the threshold to the 10th percentile, then this record-low rate run extends to 131 days, as shown below.

Credit Sector Yield Percentiles

Source: Bloomberg Finance, L.P. BofA Merrill Lynch, as of May 31, 2021. Broad high yield = ICE BoFA US High Yield Index, BB-Rated = ICE BoFA BB US High Yield Index, B-Rated = ICE BoFA B US High Yield Index, CCC & Lower = ICE BoFA CCC & Lower US High Yield Index = US IG Corporates = ICE BoFA BB US Corporates Index Past performance is not a guarantee of future results. Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in an index.

Little Difference Among Yields

Beyond the low percentile rankings, the yield levels are also closely bunched together. The differential between the highest and lowest yield among these five segments is just 4.76% – a level that plots in the lowest 4th percentile historically.

This doesn’t occur only because yields themselves are low, however. There were 33 days in 2013 when each of the five segment’s yields was below the 10th percentile, as shown above. Yet, in those time periods the yield differential was 6.3% – a figure that was in the 23rd percentile historically. The Jackson Pollock-esque scatter plot below confirms how uncorrelated those two metrics are (yield level and dispersion of yields), as well as how anomalous the current situation is.

Percentile Rankings: Dispersion versus Average Level

Source: Bloomberg Finance, L.P. BofA Merrill Lynch, as of May 31, 2021. Past performance is not a guarantee of future results. Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in an index.

Loans: High Income Potential with Less Downside

Naturally, this rally has pushed bond prices higher, and credit spreads tighter. For broad high yield, prices are in the 94th percentile and spreads are in the bottom 8th percentile. This indicates limited further upside appreciation from additional spread tightening – creating an asymmetric total return profile to go along with a low historical yield (4.1%). In fact, all credit rating bands are trading above par, except CCC & Lower-Rated issues which trade at an average price of $99.26. While not above par, that level is in the 99th percentile historically – so quite stretched.

Senior loans with their 3.7% yield, however, may offer a more symmetrical return profile in the below IG universe for income seeking investors. The average price on senior loans remains below par ($98.08). And as shown below, even though loans have outperformed HY this year (2.9% versus 2.3%), and rallied considerably off pandemic lows, the average price on loans just recently broke above pre-pandemic highs, unlike the trend in broad HY.

Loans versus High Yield: Average Price

Source: Blackstone Credit as of May 31, 2021. Past performance is not a guarantee of future results. Performance of an index is not illustrative of any particular investment. It is not possible to invest directly in an index.

There are also strong macro tailwinds for loans compared to fixed rate HY. Because the base rate of the floating rate component is usually one- to three-month LIBOR, the duration for senior loans is usually between 30 to 90 days. Thus, if inflation increases and interest rates rise further (as the consensus has forecasted), the loan category — as a result of its lower duration — may hold its value better than other credit instruments. And, if the Federal Reserve raises rates to temper any inflationary headwinds — and short-term interest rates (LIBOR) increase —- then the loan coupon also increases.

Senior loans are also less volatile than HY as a result of being more senior in the capital structure. So, if the credit rally stalls during the reopening, senior loans’ potential downside risk is less than HY – based on lower relative levels of volatility (5.6% vs 7.4%).

Tight Market Navigation

Yields for IG credit, broad HY and different rating bands are all historically in the bottom decile. And in some cases, the yields are the lowest on record. These spreads, yields and average bond prices paint a picture of tight credit markets.

Yet, while tight, the environment for credit remains constructive given accommodative monetary policies, improving corporate profits and rebounding economic data. So, excluding credit exposures in bond portfolios could be limiting on both an income and total return basis.

Therefore, given the macro backdrop and structural foundations, senior loans may help you to navigate these tight credit markets on both a total return and income basis as the reopening recovery continues.

Check out more charts like the ones in this blog, in our monthly chart pack.

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