We’re back on recession indicator watch today with a look at US corporate bond spreads. The idea here is that fixed income investors are twitchier about macroeconomic conditions than equity holders. Here’s why:
- Companies pay their bond coupons in cash, not fudge-able accounting earnings. If the economy is set for a slowdown, fixed income investors should quickly reset bond prices to incorporate that risk.
- Issuers come to the fixed income market for financing far more frequently than they tap equity markets. Corporate bond market sentiment decides where the marginal deal prices or if it gets done at all, so quality matters to the survivability of individual credits in a downturn.
There are 3 sorts of US corporate debt that might signal recession risks by requiring higher yields relative to Treasuries in order to clear the market:
#1: Investment grade (IG) corporates. While these are generally considered “safe” credits, their spreads over Treasuries still vary through the cycle.
- The current spread over Treasuries for IG is 118 basis points today, lower than its 5-year average of 134 basis points and close to its 1-year lows of 111 basis points.
- You can see a long run chart here: https://fred.stlouisfed.org/series/BAMLC0A0CM
#2: BBB corporates. Right at the cusp of investment grade and junk, these bonds should feel a macroeconomic chill before the rest of the IG universe.
- The current spread over Treasuries is 152 basis points, also lower than its 5-year average of 175 bp and (like IG generally) near its 1-year low of 141 bp.
- Long run chart here: https://fred.stlouisfed.org/series/BAMLC0A4CBBB
#3: High yield (“junk”) corporates. Bonds for the least credit-worthy companies on the spectrum should respond most dramatically to recession fears.
- Junk bonds currently pay 402 basis points over Treasuries, and like their IG and BBB counterparts this is below the 5-year average of 459 bp. Unlike more conservative credits, however, these spreads are far away from their 1-year lows of 316 bp.
- Long run chart here: https://fred.stlouisfed.org/series/BAMLH0A0HYM2
The takeaway from this first cut at the data: there is remarkably little recession fear baked into corporate bond prices today:
- All three are pricing tighter to Treasuries than their 5-year average (over which time there has obviously been no recession).
- In 2 of the 3 cases (IG and BBB), spreads are within 6 – 8% of 1-year lows.
- Junk bond spreads are +25% away from their 1-year lows, but absent confirmation from IG and BBB that does not worry us excessively.
The other way to look at this data for its power to predict recessions is to measure the rate of short-term change in spreads over time. To do that we pulled the long run data back to 1997 for:
- The 50-day change in BBB spreads versus those for all investment grade bonds.
- The 50-day change in high yield bond spreads versus investment grade credits.
- The idea behind both: to assess how riskier corporate bonds adjust over a short time frame to incoming macroeconomic data and other changes in market conditions.
There are 2 charts with this analysis at the bottom of this section, but here is what we see in the data:
- Neither is a reliable indicator of future US recession risk.
- BBB spreads versus IG moved around quite a bit from 1997 – 2008, often rising quickly over our 50-day window. A few examples: October 1998 (Long Term Capital), April 2000 (as the dot com bubble began to burst), May/August 2002 (recession caused by the 9-11 attacks), and May 2005 (during a Fed tightening cycle).
- They only started to blow out in October 2008, right along with the decline in US equity prices.
- Since the Financial Crisis, changes in the BBB spread versus IG have actually been calmer than pre-crisis.
- The change in high yield spreads versus IG credits from 1997 – present is a mirror image of the BBB/IG spreads, albeit with greater amplitude (which is what one would expect).
Summary thoughts on all this: while there is nothing in the current pricing of US corporate debt that signals imminent recession risk, we remain mindful of 2 points:
- Corporate bond markets are their own animal and worry as much about liquidity as recession risks. That makes them unreliable indicators of future economic conditions.
- The current global scramble for yield caused by negative rates in Europe and Japan and 2.0% Treasury payouts is clearly pushing capital into the US corporate bond market, especially riskier slices like BBB and junk debt. The former pays just 34 bp over IG right now versus 5-year average of 42 bp. The latter pays 284 over IG now versus a 5-year average 325 bp.
Our recommendation: we prefer investment grade corporates, even with the spicy BBB tranche, over high yield. As much as all our work on recession indicators over the last week signals an “all clear”, the risk-reward this late into an economic cycle favors a cautious approach.