The Cycle Matters - We Are Seeing That In Credit
Summary
- While corporate bond ETFs are rising, a majority of the gain has been due to lower Treasury rates as spreads are actually wider.
- Corporate bond spreads started to widen when the global cycle peaked.
- We remain in a widening phase that started in January 2018.
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The Cycle Matters - We Are Seeing That In Credit
As we enter the second half of the calendar year, optimism surrounding a rebound in economic growth is fading as signs of an economic recovery are not yet in sight. The global PMI peaked in December 2017 and has hit a fresh low as of the latest available data point.
Credit is confirming this story although there are several analysts, including high profile media pundits that continue to point at popular investment grade corporate ETFs to refute the deceleration in growth that is now greater than 18 months old.
Tuning into popular market shows and you hear comments such as "widely followed investment-grade ETF is making 52-week highs" which carries the connotation that it is credit doing the heavy lifting.
Looking at the chart below confirms the commentary above, popular investment grade ETF (NYSEARCA:LQD) is hitting a 52-week high. Does this mean the all-clear bell has been sounded?
Unfortunately not.
LQD ETF:
Source: Bloomberg, EPB Macro Research
Investment grade ETF (LQD) is comprised primarily of BBB-rated corporate bonds with an effective duration in the neighborhood of eight.
LQD ETF Breakdown:
Source: YCharts, EPB Macro Research
When we look at the effective yield of BBB-rated debt, we see a plunge in the interest rates from nearly 5.0% to 3.6%, a bullish indication as corporations can borrow at relatively cheaper rates.
BBB Effective Yield:
Source: Bloomberg, EPB Macro Research
At the same time, however, while the effective yield is declining and the LQD ETF is hitting new highs, the credit spread, or the yield on corporate paper above equal maturity Treasury bonds has been widening since the latest pivot in economic growth (December 2017).
BBB Option-Adjusted Spread:
Source: Bloomberg, EPB Macro Research
The growth rate cycle is highly important as it pertains to the health of the credit market and since the latest peak in growth, credit spreads have been widening.
Global PMI:
Source: Bloomberg, EPB Macro Research
My favorite indicator of credit risk, the quality spread, takes the difference in spreads between A-rated debt and BBB-rated debt and has been widening steadily since the pivot in economic growth.
Quality Spread:
Source: Bloomberg, EPB Macro Research
The table below shows the breakdown by credit quality of corporate bonds including the 12-month change in effective yield and the 12-month change in option-adjusted spread.
As the BBB column shows, over the past 12-months, credit spreads are unchanged but the yield on corporate debt is significantly lower, indicating that it is the decline in Treasury yields pushing corporate bonds higher, not a tightening of corporate spreads.
Corporate Bond Breakdown:
Source: Bloomberg, EPB Macro Research
Had you purchased ETF LQD, the benefit you have seen is due to a decline in Treasury rates due to slowing economic growth rather than a bullish indication coming from the credit market.
Typically, when a money manager wants to take a position in credit, the analyst only gets credit for the change in spreads which has to do with economic growth, not the change in Treasury rates. You are taking additional credit risk but only receiving the benefit of a risk-free asset. In other words, you would have been equally as well off without taking the credit risk and rather owning the Treasury bond.
Most money managers would buy a corporate bond and sell a Treasury bond to capture just the change in spread which in this case, since the pivot in economic growth, has resulted in a decline due to the widening of the spread.
We should be careful of media talking heads or analysts that suggest the rising price of LQD is a bullish indication. Credit spreads are widening and the reason that LQD is rising is due to the decline in Treasury rates rather than a bullish tightening of spreads.
The change in credit spreads is highly correlated to the rate of change in economic growth. Since January 2018, economic growth has broadly been in a phase of deceleration which is why credit spreads have widened.
At EPB Macro Research, we monitor leading indicators of growth and inflation to spot these critical pivot points, the last one occurring at the start of 2018 in which you should have moved into defensive equity sectors such as utilities and out of cyclical sectors such as regional banks.
Nominal Total Returns Since Jan 2018 (Growth Rate Cycle Pivot):
Source: Bloomberg, EPB Macro Research
Leading indicators of both growth and inflation remain lower which suggests the current trend of deceleration in growth and inflation is likely to persist for at least the next several months. With the current trend continuing, wider credit spreads remain likely.
If you own credit, consider why you are taking credit risk. Are you buying credit for the extra return associated with taking the additional risk or will you capture the same gain without the credit risk in Treasury bonds from yields declining?
The data suggests the later.
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This article was written by
Eric Basmajian is an economic cycle analyst and the Founder of EPB Macro Research, an economics-based research firm focusing on inflection points in economic growth and the impact on asset prices.
Prior to EPB Macro Research, Eric worked on the buy-side of the financial sector as an analyst at Panorama Partners, a quantitative hedge fund specializing in equity derivatives.
Eric holds a Bachelor’s degree in economics from New York University.
EPB Macro Research offers premium economic cycle research on Seeking Alpha.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.