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Don’t Lose Sight of the Forest - High Quality Credit Spreads

FICC Podcasts Nos Balados 16 novembre 2022
FICC Podcasts Nos Balados 16 novembre 2022

Disponible en anglais seulement

Dan Krieter and Dan Belton discuss the strong rally in credit following Thursday’s CPI print and discuss the level at which relative value will no longer favor overweight positions in credit. Other topics include recent ranges in credit, fair value estimates for spreads, and the health of corporate balance sheets heading into a likely economic slowdown in 2023.

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About Macro Horizons
BMO's Fixed Income, Currencies, and Commodities (FICC) Macro Strategy group led by Margaret Kerins and other special guests provide weekly and monthly updates on the FICC markets through three Macro Horizons channels; US Rates - The Week Ahead, Monthly Roundtable and High Quality Credit Spreads.

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Dan Krieter:                        Hello, and welcome to Macro Horizons High Quality Spreads for the week of November 16th, Don't Lose Sight of the Forest. I'm your host, Dan Krieter, here with Dan Belton, as we discuss the impressive rally in credit recently, and whether investors should now be considering taking some profits.

                                                Each week, we offer our view on credit spreads, ranging from the highest quality sectors, such as agencies and SSAs, to investment grade corporates. We also focus on US dollar swap spreads and all the factors that entails, including funding markets, cross-currency markets, and the transition from LIBOR to SOFR. The topics that come up most frequently in conversations with clients and listeners form the basis for each episode, so please don't hesitate to reach out to us with questions or topics you would like to hear discussed. We can be found on Bloomberg. Or email directly at dan.krieter, K-R-I-E-T-E-R, We value and greatly appreciate your input.

                                                Well, Dan, in our last podcast episode, we talked about the risk/reward in credit heading into key economic data we received in the past couple weeks. And we moved tactically overweight credit, based on the view that we thought that market optimism for a soft landing, that the Fed had achieved their mission, would likely increase amidst that data, and that we could see a pocket of out performance here. And it appears that view has paid off.

Dan Belton:                        Yeah, it has. The rally in credit that we've seen, particularly over the past few sessions, has really surpassed any expectations that I had. We really initiated that overweight, expecting some stability in credit in the near term, as there was more clarity around the Fed's reaction function. But what we got was a really strong risk on tone in response to the October CPI print. Credit spreads are now 23 basis points off of year to date highs, and 10 basis points narrower, just in two sessions this week. So we've seen a lot of out performance, and I think the natural question is, at what point do we start to unwind some of this overweight credit position that we've recommended? Given that we're at 148 basis points in the ICE index, it's really right around the long term averages.

Dan Krieter:                        Yeah, that's certainly the goal of today's podcast. But before moving on to that, I want to spend a little more time talking about the broad based recovery in credit. Because it hasn't just been a snap narrower in secondary spreads as a response to the CPI number. We've seen a significant improvement in both primary market executions, as well as the relationship between cash spreads and credit derivatives that we've talked about numerous times in the past few months, where we've seen a big divergence between the two data series, which we've attributed primarily to liquidity conditions in the cash market being very challenging for much of the past year. And so, whether we're looking at secondary spreads, primary market executions, or the relationship between cash and CDX, it's been quite a rally in IG credit spreads.

Dan Belton:                        I mean, just to put some numbers around the primary market executions, anyone who's been following the market this year knows that one of the key storylines has been really elevated new issue concessions in primary markets this year. We've had double digit new issue concessions on average, in every month since February, but that's gotten a lot better in recent weeks. This week is the fourth week in a row where we've seen concessions averaging just single digits on average, which by historical standards really isn't all that impressive. But given market functioning this year, it really is worth noting. And this week alone, just through the first two sessions, and 20 billion of supply, new issue sessions are averaging just four basis points. So really remarkable recovery that we've had, not just in secondary spreads, as you've mentioned, but also in primary markets.

Dan Krieter:                        You've talked about the improvement in concessions, and I'd argue that, that might even be understating how much executions have improved, just given the impact of heavy financial supply. Again, a theme of the year has been, extremely strong financial supply, that has resulted in a growing divergence between executions for financials and non-financial companies. In fact, looking at data since 2016, the difference in average concessions paid by financials, compared to concessions paid by non-financials, has increased to about five and a half basis points in the last three months. That may not sound like that significant a number, but it's actually the largest observation we have in our data since 2016, if we exclude the peak of the pandemic.

                                                So certainly in the past couple weeks, we've seen days of heavy financial supply, and those days are not, coincidentally, the ones that have seen the largest concessions. And if not for that heavy supply, and the impact of such heavy supply over the course of the year, concessions would likely be even lower.

Dan Belton:                        And Dan, you brought up the relationship between cash index spreads and CDX, and I just wanted to put some numbers around that as well. So over the first three months of October, we had a 14 basis point narrowing in IG CDX. Over that time, index spreads actually widened four basis points. That's a remarkable dislocation for two series that are usually very well correlated.

                                                Now since October 21st, we've seen 23 basis points of narrowing in cash index spreads, while derivatives are in a comparatively smaller, 11 basis points. So right around that third week of October is when we started to see cash spreads begin to catch up to derivatives. We saw an improvement in liquidity. That's right around the time that primary market execution levels started to really improve week over week, and that's really brought back a lot of demand from investors.

Dan Krieter:                        Yeah, we've certainly seen dealers being more willing to extend balance sheet here. The tone just feels generally much healthier across the board.

                                                So that segues nicely to, maybe the main topic of today's podcast, which is, whether or not the market might be getting ahead of itself a little bit. Obviously, we named the episode, Don't Lose Sight of the Forest. Going back to the old adage, don't lose sight of the forest for the trees. Essentially wondering, is this reaction to the most recent CPI print potentially a bit of an overreaction? And just to maybe make the argument for why it could be.

                                                Dan, you said earlier, the ICE BAML index now at 148 basis points off from the peaks of 171 basis points. But I go back to, if I could say, our guiding principle on credit, both in the near term and the long term. I think our most core belief right now in the market is that, credit spreads are likely to remain at levels that we'd likely consider at least somewhat elevated for the foreseeable future.

                                                So looking back to 2021, when we saw spreads get to lows of the low 80s, and I think we came into the year around 98 basis points. Those were extraordinarily narrow levels that we don't think were going to be returning to anytime soon. And if we look at the range for credit spreads in 2022, the lows were about 98 basis points on, I think it was actually the first day of the year. And the high point is 171 basis points, reached in mid-October. The midpoint there is really that 135, right around 135 basis points level, which we're only 13 basis points from right now. And I think just looking at it like that, like from a high level, if spreads rally another 10 basis points, we're going to get to the point where we're closer to the lows of the year than the wides of the year. And I think just from a fundamental perspective, that looks like an attractive sell point to me.

                                                And I want to talk a bit about the risk reward here. But I think that just from that high level, if we think spreads are going to stay elevated for a while here, anything below 140 basis points on the broad index level seems to me to be a pretty attractive sell. And you go back to risk reward, Dan. Risk reward was actually what drove us to initiate the tactical overweight a couple weeks ago, just based on the idea that, okay, well if CPI comes in lower than normal, there's a pretty good pocket here for spreads to kind of narrow meaningfully. And if CPI comes in high, are we really going to see that big of a reaction wider? I mean, spreads certainly widen, but will we see that strong a reaction? And we didn't think so. And so, the risk reward really favored being long spreads. I'm curious on your thoughts on how that risk reward has evolved now, since we narrowed 20 plus basis points in the past month.

Dan Belton:                        Yeah. So you mentioned that spreads came into the year around 98 basis points. And I think, when we're thinking about the environment that warrants credit spreads trading below 100 basis points, it's important to put that in context.

                                                So at the end of last year, the Fed was still engaged in quantitative easing. Fed was in the midst of this hawkish pivot, but there was no expectation that we would see a Fed funds rate of anywhere near 5%. There was also no war in Ukraine. Nor were there expectations of such geopolitical tensions flaring up in the first half of the year. So all this is to say that, credit spreads in the realm of 100 basis points, are just the result of very, very favorable macro backdrop that we're not going to get back to. So when you think about credit spreads currently, and all the risks that are in place in the market right now, that weren't in place at the end of last year, that fostered such narrow trading in credit spreads, it's hard to see the macro backdrop improve enough to warrant such narrow trading sustainably.

                                                I think we could stay around this 150 basis point range. We could potentially narrow into 140 or a little bit lower, but that would be a sell point for me. And if we look at our model for high grade credit spreads, that's calling fair value now back to about 160 basis points. Whereas, spreads were roughly fairly valued when we got to that 170 base point range in most of October. Now we're calling spreads a little bit overvalued. I do think there is some momentum on the side of credit spreads right now, where I don't want to stand in the way of that. But I think any further strength from here, where we get into the low 140s, I'd be looking to sell.

Dan Krieter:                        Yeah. And certainly, technical should be a tailwind going forward as well. But let's just talk about the risk reward, and sort of enumerate the risks facing the market in the weeks ahead. And obviously, the key risks are going to be inflation and unemployment data coming in the beginning of December, then the December FOMC. And I think, given how aggressively the market has priced in the past couple weeks, the risks to those data series have to be to widening credit spreads and response. I mean, look at inflation by itself. We know if inflation surprises the upside again, credit spreads will invariably widen. I mean, we are now priced to what I would consider essentially the minimum, in terms of further Fed rate hikes, with 50 basis points in December, 25 basis points, and then some potential for a second 25 basis point hike. I mean, I think that's as low as we're going to go.

                                                And if inflation comes into December hot once again, that pricing will have to increase. Now it won't be a 30 basis point widening, but spreads will certainly widen in response to that. And there's a reason to think that inflation could easily go higher again in December. I mean, by all metrics, the consumer remains extremely strong, which was confirmed again this morning with another very strong retail sales print. And there were some mechanical factors in the medical care cost sector in the November print, that sort of influenced CPI lower. And that's not take away, the number was very, very good, slowing really across the board. But we've seen, of course, CPI hit that 0.3% month over month number three times now in 2022. The first time, it was followed by three consecutive prints of 0.6, 0.6 and 0.7, and then we got a 0.3, and then two more monthly prints of 0.6 right back to back. So there's precedent here. There's still reason to think that inflation could stay strong. And if inflation is strong, we know credit spreads are going to wide.

                                                Now, what about if inflation continues to slow as the market expects? Then we get into a scenario where credit spreads could narrow meaningfully from here, or they could go wider, if the economic data starts to really roll over here, and it starts to look like the Fed maybe did over tighten. So when viewed to that very simplistic lens of risk reward, it starts to seem to me that the risk is tipped towards wider spread. So if we get an opportunity to sell sub 140 on the broad index, I'll be looking to do that.

                                                And of course, we talk about spreads could narrow, or they could widen if inflation does cool, that is what the market expects now. So maybe it's worth talking a bit about that. And obviously, the answer to that question will be determined by both, how quickly the economy slows, and how well corporations fare through that slowdown. And to that point then, we've gotten to a point now where Q3 earnings are, by and large, in now for almost all corporations, so we can get a robust updated look at corporate balance sheet health. And I'd say, that is one thing that continues to provide support for corporate spreads here, is that corporate balance sheets continue to stay relatively strong, even in the face of the slowing economy.

Dan Belton:                        Yeah, we'll talk more about our year ahead outlook in a couple weeks. But I think we're both on the same page that, in the longer run, corporate fundamentals are going to play a key role, given the continued monetary tightening and what that might mean for a growth slowdown.

                                                So when we look at corporate balance sheets, they remain very strong from a high level. Interest coverage ratios are near all time highs, although this was the first quarter that they have actually weakened materially from one year earlier. So that's something to keep an eye on. And that's been due mostly to the denominator effect. If we look at the denominator and the interest coverage we measure, using operating income to interest expense, and interest expense has been up 5% quarter over quarter for the past two quarters for the aggregate high grade borrower universe that we track. So that interest expense has weighed on interest coverage a little bit, but interest coverage remains strong, as revenue streams are very, very good for the universe as a whole.

                                                I think it's instructive right now to talk about zombie corporations, which is something that has gotten a lot of coverage over the course of the business cycle, as corporations have loaded up on cheap debt. And now as the Fed has tightened, this debt is coming due, and interest costs are increasing. So we looked at the proportion of the high grade and high yield indexes, that are populated by what we could consider zombie corporations. Which we classify as a corporation, which over a rolling four quarter period has seen greater interest expense than operating income.

                                                And what we see is a pretty interesting divergence between high yield and high grade. So if you look at the high grade universe, just about 4% of those corporations have seen greater interest expense than operating income over the past year. But in the high yield universe, we see about 27% of corporations that could be considered zombies, and that's near the highest level that we've seen on record, excluding the pandemic, and excluding the financial crisis. So this illustrates, to me at least, that as the economic slowdown that we're expecting to take hold in 2023, really starts to weigh on corporate balance sheets, investors are going to want to be selective about the corporations that they're exposed to.

Dan Krieter:                        And you look at where the market's pricing at now. You look at a simplistic measure like CDS spreads. Yes, they are elevated compared to the historical average, but we're still well below certainly 2020 and 2008, but we're below the level seen in 2011, 2012, 2015, 2016, and 2018. So credit concerns, while elevated, are not at what we'll likely consider peak spreads for the current economic cycle. Looking ahead to 2018, and Dan, you said we'll lay out our long term expectations. We're going to have a 2023 outlook podcast here in a couple weeks. We'll talk a bit more detail about that. But certainly, fundamentals setting up to be a much more important story in the new year, after 2022 was essentially dominated by inflation.

Dan Belton:                        Yeah, inflation and a rapid repricing of Fed policy, which really drove elevated volatility and poor returns for credit.

Dan Krieter:                        Quick programming note here. We won't be recording next week, given the holiday in the US, so we'll take the opportunity now to wish all of our listeners a very happy Thanksgiving, and express our sincere gratitude to you once again for listening, and helping support our work. Happy Thanksgiving.

Dan Belton:                        Thanks for listening to Macro Horizons. Please visit us at, as we aspire to keep our strategy efforts as interactive as possible. We'd love to hear what you thought of today's episode. Please email us at Daniel.Belton, B-E-L-T-O-N, at You can listen to this show and subscribe on Apple Podcasts or your favorite podcast provider. This show is supported by our team here at BMO, including a FICC Macro Strategy group and BMO's marketing team. This show has been edited and produced by Puddle Creative.

Speaker 3:                           The views expressed here are those of the participants, and not those of BMO capital markets, it's affiliates, or subsidiaries. For full legal disclosure, visit horizons/legal.

Dan Krieter, CFA Directeur, Stratégie sur titres à revenu fixe
Dan Belton Vice-président - Stratégie sur titres à revenu fixe, Ph. D.

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