The Deafening Sound of Silence: U.S. Credit
The U.S. credit markets, both investment grade (IG) and high yield, have largely been trading flat for the last six weeks or so, while the equity rally continues.
Somewhat surprisingly, credit spreads – as measured by option adjusted spreads (OAS in the chart) – are no longer tightening while equities continue to climb. See below.
Close 
In addition, our second chart shows the recent behavior of high yield spreads by credit rating. The chart shows that the credit classes, that should be most in-line with equities, are trading flat to wider (see CCC rated debt) …running contrary to equities.
Close
How are flat credit spreads interesting?
Equities are soaring and U.S. macro-economic data are surprising to the upside. This combination would normally result in tighter credit spreads. This good news is currently being offset by bad news.
Many bad habits were developed during the expansionary period. To wit, poor balance sheet management over the last few years has resulted in big increase in the number of companies with the lowest investment grade credit rating (BBB). Some of these low investment grade (IG) names are now at risk of being downgraded, resulting in a number of bellwether firms possibly being pushed into junk status.
The Bloomberg chart below 𝘀𝗵𝗼𝘄𝘀 𝗼𝗻𝗲-𝘁𝗵𝗶𝗿𝗱 𝗼𝗳 𝗘𝘂𝗿𝗼𝗽𝗲𝗮𝗻𝗕𝗕𝗕- 𝗱𝗲𝗯𝘁 𝗺𝗮𝗿𝗸𝗲𝘁 i𝘀 𝗰𝘂𝗿𝗿𝗲𝗻𝘁𝗹𝘆 𝗼𝗻 𝗻𝗲𝗴𝗮𝘁𝗶𝘃𝗲 𝗼𝘂𝘁𝗹𝗼𝗼𝗸, putting these bonds on the cusp of becoming junk.
Close
Loss of investment grade status means forced selling for many bond investors, that are not allowed to hold non-IG debt. In addition, contagion can result in a domino effect…meaning, we could be on the precipice of an avalanche of credit downgrades.
Esoterica's statements are not an endorsement of any company or a recommendation to buy, sell or hold any security. For full disclosures, click here.
