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Credit markets: the coronavirus crisis in five charts

The market sell-off and spike in volatility have left investors reeling. While history doesn’t always repeat itself, it often rhymes and a closer look at the data indicates there are lessons we can learn from previous drawdowns.

Key points

  • Credit spreads are at levels that have historically been followed by periods of positive returns.
  • As in 2008, credit curves inverted in the initial stage of the sell-off but have since steepened.
  • Investors have favoured credit-default swaps (CDS) over cash bonds amid the uncertainty.
  • There was an indiscriminate sell-off in both higher- and lower-quality credit during the first leg of the drawdown.

Navigating stormy waters: lessons from history

The extent of the recent sell-off has been unprecedented: historically, it has taken much longer for credit spreads to adjust to market turmoil. During the current drawdown, it took a month for high-yield credit spreads to rise from 350bps to 1,000bps, a move that took a year to play out during the global financial crisis.

But while the unwinding has occurred at a rapid pace, the nature of the sell-off is familiar. The Q4 2018 shakeout is the most recent example of market volatility, although monetary easing was enough to stabilise the market in this instance. During the current drawdown, the perfect storm of a global pandemic, oil-price war and interest rates at record lows prompted a market move that is comparable only to the financial crisis (see figure 1).

Figure 1. Credit spreads spike

Source: ICE Bond Indices, as at April 2020.

Can elevated spreads lead to higher returns?

In late March, global credit spreads breached 400bps for the first time since 2008. While spreads have since tightened, they remain high and history suggests these levels are typically a good entry point for investors with medium-term horizon. Looking back over the past 20 years, periods when spreads were above 400bps have been followed by an average return of more than 20% over the next 12 months (see figure 2). 

Figure 2. Returns could pick up in the coming months

Source: ICE Bond Indices, as at April 2020.

Topsy turvy: credit curves invert

The market drawdown prompted the spreads of one- to three-year investment-grade bonds to rise above that of seven- to 10-year bonds. This inversion last happened during the financial crisis, and is a signal that investors are selling what they deem to be the most liquid areas of the market.

In this kind of environment, it is expected that high-yield curves will flatten and invert as the riskiest debt starts to reprice to recovery.1 In addition, lower-rated securities tend to be shorter-dated than higher-quality credits and underperform as the economy takes a hit.

Meanwhile, investment-grade issuers often have more short-term maturities. This is due to the assumption that these companies can access capital markets during most situations, or that they should be able to operate regardless by drawing on their revolver-credit facilities or reducing shareholder distributions.

A sign that the market is stabilising is when firms can access capital markets and refinance their upcoming maturities. As a result, it is encouraging to see curves steepen (see figure 3). Nonetheless, this is a trend that has some way to play out – and is an important one for investors to watch.

Figure 3. Credit curves recover from record lows

Source: ICE Bond Indices, as at April 2020.

Will cash remain king?

Extreme uncertainty has prompted CDS to outperform cash bonds in recent months. When flows are hard to predict, investors tend to favour instruments that require a lower cash outlay to build a larger cushion against volatility. This has resulted in negative basis in the market, meaning that bond spreads have trader wider than that of CDS (see figure 4).

Figure 4. Negative basis is set to normalise

Source: ICE Bond Indices, as at April 2020.

As liquidity issues abate, we expect that cash bonds will once more be in favour and that the relationship will normalise. The basis between CDS and cash has fallen from multi-year highs in recent weeks, which suggests that this part of the market is normalising.

A quest for quality: dispersion increases

The early stages of the drawdown have been characterised by an indiscriminate sell-off in securities that are the easiest to sell, which tend to be higher quality and more liquid. Differentiation between higher and lower-quality credits also only started to occur later on in 2008, as names that were able to withstand macroeconomic pressure started to outperform (see figure 5).

Figure 5. Higher-quality credit recovers first

Source: ICE Bond Indices, as at April 2020.

We have witnessed a similar phenomenon during the current sell-off, as higher-quality names have performed well during the recent market bounce. As earnings season unfolds over the next month, the increase in defaults and ratings downgrades should support this trend.

Looking ahead: the new normal

Although credit spreads have fallen from their record highs, investors should be prepared for a further widening. But while the outlook is uncertain, we believe that there are clear opportunities for fixed-income investors with a medium-term outlook. As we discussed in our recent thought piece, the must-pay nature of credit coupons means the asset class will be increasingly attractive in an environment when dividends and share buybacks are in doubt.

Defaults and downgrades will clearly pick up going forward, which should increase dispersion in the market as higher-quality credits start to outperform lower-quality instruments. We will closely monitor credit curves and negative basis in the market for further signs of normalisation, while continuing to capitalise on our liquid, up-in-quality bias – something we believe should help us weather the storm in the months ahead.

  1. 1If all maturities trade at the same cash price, the shorter-dated maturities will offer a higher spread as the convergence to par on maturity takes place faster.

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