Giving undue credit?



Oliver Blackbourn & Jamie Sandells of the Janus Henderson UK-based Multi-Asset Team on the reported decrease in corporate credit quality and the impact on US IG corporate bond credit spreads.

Among the various warning messages circulating recently, the decrease in corporate credit quality has featured heavily. The shift has been sizeable but we wondered what impact it should have had on the average credit spread of the US investment grade corporate bond market. Have we been relying on a historic comparison that wasn’t valid anymore? Thankfully, it turns out that not much should have changed.
The split of credit ratings in the US dollar investment grade corporate bond market has shifted significantly as the amount of bonds in the BBB-rated (or Baa-rated, depending on the agency) has expanded. Back at the end of the millennium, BBB-rated debt equated to around 30% of the total market size. Over the last 19 years, this proportion has grown to 50% of the corporate bond market. Many point to this as a fundamental change in the nature of the corporate bond market. Therefore, we wondered if we were making a mistake when comparing the current average spread of the market to history.
Composition of the US investment grade corporate bond market by credit rating

 Source:  Janus Henderson Investors, Bloomberg, as at 10 June 2019

To examine the effect, we wanted to approximate the impact on the average credit spread of the US investment grade market that the changing credit rating mix should have caused. We took the weighting for each credit rating segment (AAA, AA, A & BBB) at the end of 1999 and rebuilt the overall index through time. We then compared this re-weighted index to the average credit spread of the US market over time. As you might expect, the credit spread was wider; however, the difference today would only be about 15 basis points, or around 10-15% wider.
Reweighting the index results in only fractional change
 Source:  Janus Henderson Investors, Bloomberg, as at 10 June 2019

In truth, we were surprised at just how small the overall difference was given the scale of the shift into BBB-rated debt – around a 20% shift in total. It is also worth noting that the impact has mainly come after the Great Financial Crisis. As the following chart shows, credit spreads are now over 10% wider (14 basis points in actual spread terms) than they would have been. While there was a spike following the tech bubble that reset fairly quickly, there has been a more persistent shift post-2009. While not covered in detail here, we can see a much more significant change in the euro investment grade corporate bond market. However, the euro market has been through greater change over the same period, with the weight in BBB-rated debt rising from below 10% to 50%, and the segment covering both AAA and AA-rated bond falling from 60% to 10%.
Relative impact of changing credit rating mix on US investment grade credit spreads

 Source:  Janus Henderson Investors, Bloomberg, as at 10 June 2019
From a multi-asset perspective, the impact on the credit spread of the overall US investment grade market seems fairly minor, in the context of swings in credit spreads over a market cycle. For those in need of income, this slight increase in spreads may be a (very) small relief given the higher average coupon at a time of low yields, although it is important to note that this higher rate of return does come with a higher attached risk. However, in the end we feel comfortable that historical spreads remain a reasonable comparator for the US market today.
US credit spreads currently reflect greater uncertainty - be that political, economic or higher leverage. They do not reflect a cheap market but we think that investment grade bonds sit well within our multi-asset portfolios, particularly given our preference for mid-risk assets in a post-stimulus environment.

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