If you are a credit investor, you should be worried right about now.
For one thing, you could be a hermit whose only connection to the outside world is a chart of IG and HY credit spreads that updates daily and still know it’s time to take some off the table. The spread compression off last year’s deflationary doldrums is mammoth.
So there’s that.
But let’s say you’re not a hermit and you have some conception of what’s happening in terms of central banks looking to roll back accommodative policy.
Well in that case, you’re probably aware that central banks are keeping a lid on spreads both indirectly (by maintaining the generalized flow of liquidity to markets) and directly (by buying corporate bonds). It stands to reason then, that when that backstop fades, spreads will widen. See “And The “Biggest Risk” To Credit Markets Is…”
What US credit investors (especially in IG) should also consider is that foreign flows will dry up as the policy divergence between the Fed and the ECB becomes less pronounced. Put differently, if rate differentials compress in favor of the euro and later, the yen, well then one of the pillars underpinning the bid for USD credit crumbles.
With that in mind, consider the following brief color from BofAML…
The biggest risk
We have long maintained that the #1 risk for US high grade corporate bond spreads is a big increase in global interest rates, led by foreign countries. In that situation we could lose the foreign inflows that dominate buying in our market, get a rates shock domestically and large retail investor outflows from bond funds and ETFs.
To see why this is a major risk scenario consider that over the past ten years – i.e. since the early stages of the financial crisis just before the short term markets froze in the second half of 2007 – the size of our market has tripled to ~$6.3tr in market value (Figure 10). That expansion was driven initially by the Fed’s super-easy monetary policy generating positive bond price performance that attracted retail inflows to bond funds and ETFs (Figure 11). Then increasingly in recent years yield sensitive foreign investors have taken over driven by super-easy foreign monetary policy easing and ultra–low interest rates abroad, especially in the Eurozone and Japan.
Hence the risk of a partial unwind leading to much high yields – including significantly wider credit spreads – when foreign central banks tighten monetary policies.
The foundation of our bullish outlook for high grade credit spreads is that foreign (including Eurozone) core inflation remains low. That such condition remains in place was certainly emphasized in Draghi’s speech and, as our European economist highlight, this means that the coming monetary policy exit will be very slow and the ECB will still be doing sizable QE for quite some time. We think that the biggest risk is triggered if Eurozone or Japanese core inflation surprise to the upside and the markets re-price ECB and BOJ QE.