Corporate Credit Valuation in a Historical Context
At Smith Capital Investors, we are always looking for insights into what the markets are telling us and how these insights can inform our investment process. One key issue we find ourselves pondering is the probability that the Fed will be able to orchestrate a so-called “soft landing”, and in conjunction how will risk assets perform if the Fed is successful or unsuccessful in accomplishing their goals. We turned our attention toward corporate credit markets to provide further insight into the matter.
Looking at the last three NBER designated recessions (2001, 2007-2009, and 2020), the weighted average Option Adjusted Spread (OAS) for the Bloomberg US Corporate High Yield Bond Index (HY Index) during these defined recessionary periods was 945 basis points (bps), with peak spreads much higher than these levels. In investment grade credit, the OAS for the Bloomberg US Credit Index (IG Index) averaged 275 bps over these periods. For all other non-recessionary periods since 2000, the OAS for the HY Index and the IG Index averaged 487bps and 127bps, respectively. So how do these levels compare to current market pricing? As of 9/9/22, the HY Index OAS stands at 449 bps and the IG Index level was 131bps. While past performance may not be a good proxy for future results, current corporate credit spreads are close to historical non-recessionary levels and appear to be pricing in a low probability of a return to previously observed recessionary spread levels.
Another issue we frequently wrestle with is how much weight to assign to current yield levels (elevated vs history) vs spread levels (less favorable on a historical basis) when considering the attractiveness of the current market. Comparing historical yield-to-worst (YTW) metrics during recessionary and non-recessionary periods, we are left with similar findings to the OAS analysis above. While current YTW levels on the HY Index and IG Index are 16% and 28% above the post-2000 non-recessionary averages, these figures are still well below YTW levels seen during historical recessionary periods.
Comparing current spread and yield levels in US corporate credit markets to prior recessionary and non-recessionary periods, investors may conclude that these markets are pricing in a low probability of a near-term recession. While we are not confident in the ability to accurately predict a recession, we do feel that current market pricing incorporates a relatively benign view of the future, particularly given the unprecedented nature and magnitude of many important macroeconomic variables at play. That said, we continue to maintain a defensive posture in corporate credit with an emphasis on resiliency. No matter what future conditions materialize we know that the impact on individual company growth, earnings, and cash flows will be differentiated. As such, we are spending our time hunting for securities that may possess a more attractive risk/reward profile than the broader market.
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