Chart 1) shows the link between 10-yr Treasury yields and US BBB-rated corporate bond spreads in the very latest cycle from before the Covid-19 crisis up to the present day (ultimately a one-year span). Divergences vs previous cycles are significant not only in macro dynamics but also in market behaviour, which appears quite clearly in the chart. Hereby we summarise three main differences with the past:
Firstly, while much more severe than past GDP contractions, the 2020 recession was also quite short, actually lasting just four months from the end of February to June.
Secondly, contrary to previous experiences the peak in corporate spread occurred much earlier than usual, roughly just one month into this short recession.
Finally, rates started to normalise later than usual, as between February and November the US 10-yr yield moved sideways, within a limited range, and really started to trend higher in December following positive news on vaccines and fiscal packages. In January and so far in February, the trend has accelerated on the back of new expectations of stronger fiscal stimulus and more rapid recovery, following the democratic success at the US Senate run off elections.
Getting more deeply into the numbers, BBB spreads compressed by a remarkable 325bp move from the 465bp recessionary peak touched on March 20th to the 140bp area by end of November, while over the same period, the 10yr Treasury yield decreased slightly, from 96bps to 84bps, remaining in a trading range. The subsequent move was quite different, as spreads tightened further but to a much lower extent than in the previous phase, namely decreasing from 140bp to 122bp at this writing, actually even below pre-Covid crisis levels. Over this latest period, the corresponding move by the US Treasury was a meaningful increase, as 10yr yield rose by more than 40 bps.
In a nutshell, a period of spread normalisation took place before the yield could start to rise. Monetary and fiscal policies were successful in cutting this credit cycle quite short, both limiting the extent of the spike in spreads and triggering a very rapid compression in risk which started after just one month from the crisis. In simple terms, the best of the credit cycle seems to be behind us (in terms of spread tightening and excess return delivered on government bonds), as the normalisation of credit risk premiums has already taken place, especially relative to bond yields.
At the same time, a milder upward trend in bond yields may take place looking forward if central banks continue to target preserving favourable financial conditions and in light of the move already delivered by fixed-income markets. Therefore, although credit valuations look like headwinds to spread compression and to the renewal of the usual link with rates, we may also expect central banks to keep an accommodative stance in order to avoid extreme moves in curve steepening, which could ultimately endanger the recovery through tighter funding conditions and higher volatility in financial markets. The legacy of the Covid-19 crisis, as we have underlined many times, is a much higher volume of both public and private debt.
Another peculiarity of this very rapid cycle is the lagged start in the deleveraging process by companies. The latter has also to do with the success of monetary and fiscal policies in avoiding a credit crunch and ensuring easy financing conditions for corporates, in the US mainly through the corporate bond markets, in Eurozone mainly through the bank loan channel. The economic recovery will support the return to lower leverage levels, sustained as well by the likely gradual use of the huge liquidity buffers built to withstand the economic and financial effects of the crisis, but this process will take some time, as companies entered the crisis with already relatively high debt ratios by historical standards.