As fixed income investors, a fundamental step in our analysis is to interpret credit spreads, or credit premiums. This is the difference between the yield on a corporate bond and a government bond of the same maturity. The difference in yield is intended to compensate for the additional uncertainties of investing in corporate credits, or lending to corporations rather than sovereign nations. Such risks include default risk, anticipated capital recovery rates in the case of a credit event, and liquidity premium as corporate bonds are typically less liquid than government bonds. Because they are embedded in corporate bond prices, which are affected by market demand, credit premiums give valuable insights into market sentiment and expectations concerning the aforementioned risks.
CREDIT PREMIUMS ARE DECREASING
Since late 2023, we have seen credit premiums quickly contracting in the North American corporate credit market to levels below the long-term median and approaching historical lows. This is evidenced by the below chart, which shows the spreads for U.S. corporate bonds are nearing what have been typical trough levels. Spread compression has also been experienced between corporate bonds with different credit ratings. This means that there is less differentiation in bond valuations between stronger and weaker borrowers. In short, we are seeing lower compensation for additional risk associated with lower quality bonds.
Source: Bloomberg
DRIVING FORCES BEHIND SPREAD TIGHTENING
It is difficult to pinpoint the reason spreads are reducing, but there could be a few factors at play.
In recent months, there has been a steady inflow of funds into fixed income at the expense of equities, as seen in the chart below. Higher all-in yields for fixed income securities seem to be attracting more investors into the space, driving prices up and yields lower.
There has also been a strong indication that the market has perfectly priced in the “soft landing” economic outcome. This implies that the market is not expecting there to be a hard recession and as a result, default rates, recovery rates, and liquidity, the factors that compose credit premiums, are not anticipated to be stressed.
An additional potential explanation for spread compression could be the good financial performance from a lot of the investment grade and high yield credits in the Canadian universe. Investors may be demanding less excess yield due to the strong underlying credit fundamentals.
While credit spread tightening is likely a result of all three factors, the market’s acceptance of the soft-landing narrative seems to be the catalyst for the recent spread movement.
Source: EPFR, TD Securities
WHY THIS IS IMPORTANT
The relevance of credit spreads to a fixed income investor cannot be overstated. Reduced spreads indicate lower amounts of compensation for the higher risk of owning corporate bonds over government bonds, which means less cushion against unpriced risks. There is also less cushion if the market experiences a repricing event and spreads widen, as it has in the past when spreads are at historically tight levels.
Although the timing and magnitude of such repricing events are exceedingly difficult to predict with accuracy, it is important to consider a portfolio’s positioning given the risks of a dramatic repricing are elevated when spreads are diminutive. Credit and sector exposure within a portfolio can be a benefit or detractor in times of market corrections. While we are not quite at an extreme, we seem to be approaching such a juncture. We can use credit spreads as a map to understand the risks perceived by the market and, by focusing on bottom-up credit analysis, we can act when we see a different balance between risk and reward. Focusing on finding areas with sufficient margin of safety where we believe we are compensated for risks can assist in avoiding pitfalls and provide a benefit should unpriced risks in the market materialize, and credit spreads widen.
WHAT THIS MEANS FOR OUR FIXED INCOME TEAM
Corporate credits remain an important part of the QV Canadian Bond and Balanced Funds as they provide additional interest income over that of government bonds. We do not see this as a time to drastically reduce or make large shifts in the corporate bond weight in the fund, but rather an opportunity to improve the portfolio’s risk adjusted return outlook.
Given that valuations are converging at high levels across different credit ratings, this has been an opportunity to high grade quality and liquidity within the fund. It also has provided the potential to trim in areas where spread compression has eroded some of the margin of safety, as identified by our active fundamental credit research. By following our bottom-up credit analysis process, we’ve been emphasizing resilience within the portfolio by bolstering positions in companies with strong capital allocation principles, good management teams, and strong franchises, and reducing holdings with weakness in these areas. For example, we were able to improve the average credit rating of the fund by selling our BBB- rated Cogeco bonds and investing in BBB rated Pembina bonds. We view Pembina’s credit trajectory as stable as this management team has stayed committed to their financial guardrails over time, whereas Cogeco’s leverage had increased recently due to some capital allocation priorities. Because of widespread credit premium compression between bonds of different ratings, we were able to upgrade on credit quality with minimal yield spread sacrifice.
We are proceeding with caution as we navigate this environment, while recognizing that we can act where we see opportunities to continue to promote capital preservation and attractive risk adjusted returns. With premiums converging across credit ratings, we have the opportunity to focus on holding higher quality bonds with minimal sacrifice to yield, which will benefit the funds resilience should credit spreads widen from this level.
