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A tale of two markets

So far this year fixed income investors have witnessed the best of markets and the worst of markets. And though the extreme contrast between hope and panic has left some investors nervous, it’s important to underscore that we have seen tremendous improvement in credit markets since the peak of the crisis in late March. We have not fully digested all the economic (not to mention human) costs of this pandemic, and thus investors should not be surprised if bouts of volatility return. Still, there is reason for cautious optimism, even though credit investors will need to discern between the post-pandemic winners and losers.

After peaking at 373 basis points (bps) in March, corporate credit spreads stabilized by mid-April and finished the month at 202 bps.¹ As a reminder, credit spreads are the additional compensation investors require for holding securities that aren’t as safe or liquid as those issued by the U.S. Treasury. Widening spreads reflect investors’ perception of rising risks, while declining spreads reflect investors’ perception of decreasing risks.

These credit spreads remained largely flat through mid-May, then resumed tightening (i.e. improving and suggesting less credit risk) as all 50 states eased lockdown restrictions. Credit spreads ended May at 174 bps, more than 200 bps tighter than in March.¹

Why the impressive turnaround? For starters, the actions by the Federal Reserve and Federal government indicated that the initial panic over the virus and its impact on the economy were extreme. Subsequently, investment grade credit spreads reflected credit investors’ moderating concerns over the overall health of the fixed income market. As investor sentiment improved, the primary market re-opened and companies were able to issue bonds again. In fact, demand for new issuance has turned out to be quite robust. What started as a tentative trickle of new issuance in mid-March quickly became a deluge, nearly doubling the amount seen during the first five months of 2019. Companies of all sizes and sectors have sought to access the market to bolster their liquidity and refinance coming maturities.

While that’s an excellent sign, it’s also important that investors maintain a healthy dose of skepticism. There will be fallout, even bankruptcies, in the post-pandemic economy. Credit rating agencies already have been busy assessing corporate credit quality, and downgrades have far outpaced upgrades. Some companies will fall below investment grade, while others in the high yield category may even default. Fundamental analysis and risk management will be critical going forward.  

Although potentially rising default rates present a risk to fixed income investors, defaults tend to be a lagging indicator of stress in the credit markets. In contrast, credit spreads, which have been improving, tend to be more forward looking. Thus, even if slower economic growth is projected going forward, it does not mean that the current environment will be a poor one for credit investors. 

¹Credit market represented by the Bloomberg Barclays US Aggregate Corporate Bond Index.  Index credit spreads were derived by taking an average of all the index constituents.  Spreads are option-adjusted.
Source: Bloomberg, as of April 28, 2020

Victory Capital, Inc. is a Registered Investment Advisor. The information in this article is based on data obtained from recognized services and sources and is believed to be reliable. Any opinions, projections or recommendations in this report are subject to change without notice and are not intended as individual investment advice. Not to be used as legal or tax advice.

©2020 Victory Capital Management Inc.
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