Spreads Largely Pricing in a Full Recovery

May 26, 2021 | Mollie Zugger, Research Associate, Ben Mohr, CFA, Director of Fixed Income, Managing Partner

Two line charts showing Bank Loan and High Yield Spreads. Chart subtitle: Bank loan and high yield spreads are now tighter than they were pre-pandemic. First chart description: Left y-axis shows Bank Loan Spreads, ranging from 0bp to 2,500bp. X-axis shows months in two-month increments, from December 2019 to April 2021. Second chart shows the same for High Yield Spreads. Lines in each chart are the same industries: Energy (Beat-Up), Retail (Beat-Up), Transportation (Beat-Up), Financial (More Stable), Tech (More Stable), and Utilities (More Stable), with descriptors applied to those industries that fared better or worse throughout the early 2020 COVID panic. In both charts, all industries spiked in March 2020 and have since fallen to pre-pandemic levels. Chart source: Credit Suisse Leveraged Loan Index 3-year discount margin over LIBOR and High Yield Index Spread over Treasuries.

Spreads for industries that were beat-up during the early 2020 COVID panic — energy, retail, and transportation — as well as for industries that proved more stable — financials, technology, and utilities — are now generally tighter than pre-pandemic levels in the bank loan and high yield markets. From here, spreads could tighten further as issuer fundamentals continue to improve, widen in a correction, or be volatile, blowing out and tightening back in throughout the economic recovery.

While a lot of progress has been made on the vaccination front, there is still more work to do. The fully vaccinated rate in the U.S. is currently 39%, not yet at 70% herd immunity. Globally, the fully vaccinated rate is only 5%, not even close to 70% herd immunity. While this leaves the economic recovery vulnerable, markets are forward-looking. In the bank loan and high yield markets, maturities have been pushed off, which is a positive, thanks to the large volume of issuance over the past year. Leverage levels of bank loan and high yield issuers are currently high, but due to decline, another positive, as earnings rise in the economic recovery. Use of proceeds from bank loan and high yield issuances¹ and aggressive issuance² are at benign levels, and defaults have been declining — more positive indicators. On the negative side, equity valuations are already at all-time highs and continuing to rise.

In summary, fundamentals are attractive, but valuations are not. We could potentially see spreads tighten further, but uncertainty is high, and we could also see a correction given the high valuations and frothy sentiment. While further spread tightening will be accretive to returns, it will limit short-term future price appreciation for fixed income strategies. Overall, this is a dynamic that bears watching, particularly as economic growth accelerates and the pandemic continues to fade.

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¹ Such as towards refinancings (a sign of conservativism) versus acquisitions and LBOs (a sign of frothiness).
² Such as CCC bank loan and high yield issuance and 2nd lien bank loan issuance.

 

The opinions expressed herein are those of Marquette Associates, Inc. (“Marquette”), and are subject to change without notice. This material is not financial advice or an offer to purchase or sell any product. Marquette reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs.

Mollie Zugger
Research Associate

Get to Know Mollie

Ben Mohr, CFA
Director of Fixed Income, Managing Partner

Get to Know Ben

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