Credit spreads have materially moved wider in the past 12 months, reflecting market anticipation of a slowing economy. One of the reasons for the widening is higher official interest rates which has increased corporate borrowing costs and refinancing risk, while also increasing the potential for a recession. This has been further exacerbated by a number of global factors influencing credit markets such as the Russian Ukraine conflict, rising energy prices, and COVID induced lockdowns in China, to name a few.
Higher credit spreads are typically signals for heightened credit risk in the bond market. It is also a sign that the market is pricing in higher probabilities of defaults as investors demand higher risk premiums to compensation for increased credit risk.
As the largest corporate bond market in the world, the US market provides a good indication of an increase in credit concerns with US Investment Grade corporate bond credit spreads, referenced by the ICE BofA US Corporate Index Option-Adjusted Spread, rising 41bps over the year to 138 basis points as at 31 December 2022. (see Figure 1). The increase in US High Yield corporate bond spreads were more stark, with the ICE BofA US High Yield Index Option-Adjusted Spread rising 176 bps over the year to 481 bps as at 31 December 2022. (see figure 2)
Figure 1 – US investment credit spread has widened.
Source: FRED, 31 December 2022
Figure 2 – …so did High yield spreads
Source: FRED, 31 December 2022
Higher credit spreads also result in higher funding costs for corporates that rely on debt capital markets for funding. The low-rate environment in the past number of years has shielded financially weak companies from financial stress, however they may find it increasingly difficult to meet their debt obligations in a higher rate environment. These companies have been coined “zombie” companies, being companies that have been earning just enough to continue operating while interest rates are low.
Faced with higher interest costs and the prospect of greater refinancing risk, corporate borrowers’ poor financial health may also be compounded by macroeconomic pressures on revenue stemming from inflation and potential recession. In the event a recession does occur, this may lead to lower corporate revenues, cash flows, and interest coverage, bringing these ‘zombie’ companies to light.
Rising rates is not all bad news as one benefit of rising rates is that fixed income assets become more attractive from an outright yield perspective. This is particularly the case for floating rate instruments, as coupons will increase as interest rates increase, benefitting investors and providing an additional buffer to protect against adverse market movements. However, while these instruments are advantageous to investors compared to fixed rate instruments, they do not offer any further protection from credit losses.
Heighten risks in the credit market, primary driven by the impact of higher interest rates, has resulted in credit spreads in both the investment grade and high yield corporate bond market to significantly widen over 2022. While higher outright yields may be more attractive to investors, investors need to be wary of the increased risk of credit losses.
by Alec Leung, Senior Investment Analyst, Lonsec Research
Sources:
- FRED (https://research.stlouisfed.org/)
- Online (https://www.livewiremarkets.com/wires/up-to-one-third-of-all-australian-and-us-companies-could-be-zombies)
- ABS Total Value of Dwellings (https://www.abs.gov.au/statistics/economy/price-indexes-and-inflation/total-value-dwellings/latest-release)
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