What company credit score spreads are signalling on returns | USAEMALL.com

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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is co-founder and co-chair of Oaktree Capital Management and author of “Mastering the Market Cycle: Getting the Odds on Your Side”

The questions I get from clients enable me to understand in real time what’s on their minds. In the past few months, it’s “what about spreads?” Ever since interest rates rose off the floor in 2022, there’s been increased interest in credit. But the question of the day is whether current credit spreads — the difference in yields on corporate debt over government benchmarks — are adequate.

Promised yields on credit instruments were meagre in the low interest rate period of 2009-21. At the beginning of 2022, before the Federal Reserve embarked on its programme of interest rate rises, high-yield bonds offered yields in the 4 per cent range.

As 2022 progressed, fears of an economic ‘‘hard landing’’ led investors to seek more risk protection. The average high-yield bond spread rose to more than 4 per cent, taking the overall yield to roughly 9.5 per cent. 

These high single-digit yields alone would have given holders healthy returns. However, increased demand for credit considered below investment grade and decreasing concerns about a possible recession caused the bonds to appreciate in value, adding to total returns. As a result, the yield to maturity on the average high-yield bond now stands at just over 7 per cent.

Yield spreads primarily fluctuate with trends in defaults and the investor psychology regarding them. When more companies are defaulting and investors expect higher levels of defaults in the future, they’ll demand more protection in the form of wider spreads. The thoughtful investor has to evaluate that expression of opinion against what the reality is likely to be and assess whether investors are being too optimistic or too pessimistic. 

Let’s say high-yield bonds yield 8 per cent and a Treasury note of the same maturity offers 5 per cent, making a spread of 3 percentage points. Which is the better deal? It all depends on the likelihood of default. If high-yield bonds have a 4 per cent chance of defaulting each year and you’re likely to lose 75 per cent of your money in a default, your annual credit loss could be estimated at 3 per cent (75 per cent of 4 per cent). If those estimates are accurate, you should be indifferent between the two. 

Thus, the key question isn’t whether today’s spread is narrow or not relative to past patterns. It’s whether it is sufficient to offset the credit losses that will occur. In this respect, investors have several factors in their favour.

Firstly, even today’s narrow spread of about 2.9 percentage points would have been enough to offset the historical credit loss rate on high-yield bonds — about 2.3 per cent a year. Secondly, that historical loss rate might not be relevant to the future, as (a) it was dragged up by idiosyncratic crises and (b) central banks and national treasuries have since developed counter-recessionary tools. Thirdly, the average high-yield bond’s credit rating has risen substantially, with more than half the market now rated BB or above. The final factor is that active managers may be able to reduce the incidence of default in their portfolios. For all these reasons, I believe the concern about historically narrow spreads is very much overblown.

In addition, spread widening is a short-term phenomenon, analogous to volatility in stocks. If the yield spread widens, that results in a price decline for bondholders. But this is temporary while the higher interest payments are received every year. And when the bond eventually reaches maturity (assuming it performs), you’re repaid at par. Then you’ll have received the yield you expected, regardless of price fluctuations experienced in the meantime, including declines related to spread widening. 

Of course, investors have an alternative option to credit. I’ve recently written about equity valuations — primarily referencing the S&P 500 index — and the potential for a bubble. Suffice to say that from elevated price-earnings ratios like today’s, the S&P has historically offered very limited 10-year returns, and some investment banks have expressed return expectations in the low to mid-single digits. 

The current level of offered yields implies higher returns from credit than the S&P 500 — and with returns that are contractual and thus subject to much less variability and uncertainty. This is true despite the return contraction that has been brought on by the swing from pessimism to optimism over the past two years, and even given today’s narrow spreads. Credit isn’t a giveaway today, but it offers healthy absolute returns and is fairly priced in relative terms.