In spite of a couple of days of notable risk aversion in the past week, one of the main concerns investors have for 2013 is that credit spreads could widen due to Government yields rising.
There is little evidence that higher yields lead to wider credit spreads using historical data from the US back to 1919.
Going forward we could actually see spreads tighten if yield rises are due to improved data, however if higher yields are due to renewed sovereign spreads we could see wider spreads.
This cycle is very different to anything seen through history, if higher yields result from an expectation the FED might halt its asset purchases this may, for a time, lead to some risk reduction.
If the economy can withstand less QE then spreads could still tighten in a post-QE world, if this is not the case then further widening may ensue.
The worst case scenario for any credit market would be if yields rose because a lack of faith in the Government's ability to pay investors back as we have seen in the European Sovereign crisis.
We think the fears of wider spreads as a result of higher yields is overblown in core countries for 2013, other factors like the likely path of the economy are perhaps more important.
Eoin Treacy's view Corporate spreads have unwound most of the panicky widening that characterised the nadir of the credit crisis and are back to an area where investors can justifiably ask how much tighter can they be expected to trade. AA composite spreads are back to a little more than 100 basis points over Treasuries while BB composite spreads has returned to test the 300 basis point area. Both these levels represent historic areas of support.
In addressing these spreads let us look at both sets of components. Government bond yields have been massaged lower as central banks attempt to reignite lending growth and avoid deflation. In a benign scenario, where yields rise due to the removal of stimulus because of improving economic growth the outlook for corporate yields could be equally benign and could justify tighter spreads. In anything other than such a benign scenario corporate spreads are beginning to look pricey.
It is worth differentiating between issuers. As yields have compressed, investors have been forced to move further out the risk curve to capture yield which has led to tightening across the high yield sector. High yield bonds tend to trade more like equities than higher rated instruments. While subject to occasional bouts of volatility, equities generally remain in medium-term uptrends. This has been a tailwind for high yield bonds. A change to that outlook would have a material effect on sentiment towards high yield bonds.
Among higher rated corporates, balance sheets are generally healthy. However, companies have been increasing their debt burden as the lowest rates in a generation made capital too cheap to pass up. While this is unlikely to present an issue while businesses are growing, debt will be an issue during the next recession, whenever that occurs. As ever, we will be guided by the price action.