Muzinich Weekly Market Comment: Are spreads too tight, or just right?

November 25, 2024

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In our latest roundup of the key developments in financial markets and economies, we try to answer the big question on credit spreads.

In what was a relatively quiet week for financial markets, politics and the third quarter earnings announcement from artificial intelligence behemoth Nvidia were the main talking points.

To put Nvidia’s size into perspective, if it was a stock market, its current market capitalization of US$3.59 trillion would make it the sixth largest in the world.^[1] The company reported Q3 revenues of US$35.1 billion, almost double the same period in 2023 and above projections of US$$33.2 billion. Nvidia’s guidance for Q4 revenues came in at US$37.5 billion, aligning with consensus estimates.^[2]

While respectable enough, the relative lack of fireworks from Nvidia kept major global equity indices within a narrow range of +/-1% for the week.

On the geopolitical front, the 1,000-day conflict in Ukraine entered a new phase with the use of long-range missiles.^[3] Meanwhile, in the US, political uncertainty persisted, with continued speculation about who will be the next Treasury Secretary — on November 22, Scott Bessent was selected by Donald Trump — and Matt Gaetz withdrawing from consideration for the position of Attorney General. Pam Bondi emerged as the replacement nominee.^[4]

These political developments pushed global government bond yields lower, with European bonds outperforming. The euro continued to depreciate; it has weakened 7% against the US dollar since September. Meanwhile, commodities had a strong week with both gold and oil appreciating more than 4%.

Hold tight….

Corporate credit markets were steady last week. However, with little fanfare, US high-yield and investment-grade corporate credit spreads have tightened to their lowest levels in more than ten years (see Chart of the week).

Credit markets are not currently displaying the typical red flags of a financial bubble - leverage is not excessive, maturities have been pushed out and defaults have been contained. Furthermore, investors are under no illusion that spreads cannot widen from here. However, it is pertinent to ask: Are these tight spread levels justified?

For bottom-up investors, credit spreads represent compensation for the risks that could affect a company’s financial health through the cycle. These risks include potential rating downgrades, restructuring and, in the worst-case scenario, default. Additionally, investors typically want some spread pick-up for the lower liquidity of corporate bonds compared to government debt.

While many variables influence a company’s health, fundamentals depend on two cycles. The first is the economic cycle, as growth impacts production volumes and inflation affects profit margins. The other is the financial cycle, as the availability and cost of funding influence a company’s financial flexibility. In our view, both cycles currently look favourable for credit spreads. The world’s largest economy, the US, is expanding above its long-term potential, and global prices are experiencing a disinflationary trend. This has enabled central banks to loosen monetary policy, reducing borrowing costs for corporate issuers and increasing liquidity in the financial system.

Liquidity can be viewed as a function of primary market activity and volatility. As primary market activity rises, so too does price transparency and the free float of securities. Additionally, when volatility is low, confidence grows. Both variables combine to tighten bid-offer spreads. Primary market activity has been robust all year,^[5] and bond market volatility (measured by the MOVE Index) is around its one-year average,^[6] putting little upward pressure on spreads.

View from the top

For top-down — or macro — investors, central banks and government policy are equally critical in determining the direction of credit spreads; currently, we would argue these are also supportive.

After a two-year battle against inflation, most major banks have shifted their focus onto how monetary policy can support growth and employment. This approach, often referred to in the US as the “Fed put”, originated in 1987 when Federal Reserve Chair Alan Greenspan intervened to support markets after the stock market crashed.^[7]

Many macro investors still have faith in the Fed put, seeing it as an insurance policy during periods of extreme market stress or a hard-landing scenario. This belief has led to a common approach of "buying the dips" – if spreads widen, macro investors buy.

During his first term, Donald Trump would frequently point to rising US equity prices as a measure of success and evidence that his administration’s policies were on the right track. But for a more rational explanation as to how markets behave, the words of Benjamin Graham, father of value investing, are worth remembering:

“The market is not a weighing machine, on which the value of each issue is recorded by an exact and impersonal mechanism, in accordance with its specific qualities,” he wrote. “Rather, should we say that the market is a voting machine, whereon countless individuals register choices which are the product partly of reason and partly of emotion.”^[8]

Seller’s market?

So, are credit spreads tight simply because there are more buyers than sellers? There is case to be made for that thesis.

Firstly, private credit markets have expanded aggressively, tripling in size over the last 10 years and now standing at $1.5 trillion.^[9] For corporates seeking alternative financing sources, particularly those who might struggle to access public markets, the average spread in direct lending (the biggest private credit asset class) transactions over the first 3 quarters of this year was 560 basis points.^[10]

Secondly, as government bond curves begin to normalize — sloping upwards from left to right, which allows money market yields to fall below bond yields — we could see a significant redeployment of cash currently in money markets into corporate credit markets. If assets under management in money market funds were to mean-revert to their 10-year average, up to US$3 trillion of capital would need a new home.^[11]

In Asia, interest rates are already significantly below their US counterpart, with the average policy rate standing at 2.63%,^[12] compared to the 4.5-4.75% range for the US Federal funds rate.^[13] Asian rates are also below the coupon yields achievable in US corporate bonds, which has driven a resurgence in leveraged target-date bond products after being dormant for several years.^[14]

Meanwhile, given much uncertainty around politics and trade, and following the significant rally in equities over the past 12 months — the S&P 500, for example, has risen by over 30% — investors may wonder whether this is opportune moment to look at bonds as a diversifier. This shift could be encouraged by the equity-bond correlation turning negative again in recent months.^[15]

Ultimately, what matters for investors is forward-looking total returns. Stretched valuations are unlikely to support outperformance, resulting in a weak return outlook. For corporate bonds, we would argue the yield-to-worst offers a more accurate reflection of potential returns than credit spreads.

Currently, the yield-to-worst for US investment-grade bonds is 5.25% and 7.2% for US high-yield bonds. Furthermore, both underlying indexes are priced below par at 93 and 96, respectively.^[16] For the S&P 500 and FTSE 100 equity indices, Bloomberg consensus forecasts for total returns over the next 12 months are 4% and 3.8%.^[17] When you consider that corporate bonds rank higher in the capital structure than equities, the potential return profile for credit in 2025 compares favourably.

Earlier, we posed the question: Are these tight spread levels justified? Given reasonably strong fundamentals, supportive technicals from a growing buyer base, and a relatively healthy return outlook over the next twelve months versus stocks, perhaps they are.

Chart of the week: US spreads hit 10-year low

Source: Ice BofA Platform, Ice BofA US Corporate Index (C0A0), ICE BofA US High Yield Index (J0A0), as of November 22, 2024. Index performance is for illustrative purposes only. You cannot invest directly in the index. Indices selected provide best proxy for highlighting credit spreads of US investment grade and high yield markets. For illustrative purposes only.

Past performance is not a reliable indicator of current or future results.

References

[1] Bloomberg, November 22, 2024
[2] Nvidia, ‘NVIDIA Announces Financial Results for Third Quarter Fiscal 2025,’ November 20, 2024
[3] BBC News, ‘Putin warns West as Russia hits Ukraine with new missile,’ November 21, 2024
[4] The Guardian, ‘How Trump’s nomination of Matt Gaetz unravelled in just eight days,’ November 21, 2024
[5] S&P Global, ‘Global Financing Conditions: Blockbuster Growth In 2024 With Tailwinds Heading Into 2025, October 23, 2024
[6] CNBC, Ice BofA Move Index, as of November 22, 2024
[7] Fed in Print, ‘The Fed, the Stock Market, and the "Greenspan Put,” January 2023
[8] Benjamin Graham, ‘Security Analysis,’ 1951
[9] Preqin, ‘Future of alternatives 2029,’ September 18, 2024
[10] Morgan Stanley, as of October 29, 2024
[11] Investment Company Institute, ‘Money Market Fund Assets,’ November 21, 2024
[12] JP Morgan, as of November 22, 2024
[13] Federal Reserve, ‘Federal Reserve issues FOMC statement,’ November 7, 2024
[14] Pensions & Investments, ‘Interest rates are falling. Managers employ varied strategies to reinforce fixed-income’s role in target-date funds,’ October 21, 2024
[15] Bloomberg, ‘Bonds Are Back as a Hedge After Failing Investors for Years,’ August 11, 2024
[16] Ice BofA Platform, ICE BofA US Corporate Index (C0A0) and ICE BofA US Cash Pay High Yield (J0A0), as of November 22, 2024. Indices used represent best proxies for US investment grade and high yield markets.
[17] Bloomberg, as of November 22, 2024

 

This material is not intended to be relied upon as a forecast, research, or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. References to specific companies is for illustrative purposes only and does not reflect the holdings of any specific past or current portfolio or account. The opinions expressed by Muzinich & Co. are as of November 25, 2024, and may change without notice. All data figures are from Bloomberg, as of November 22, 2024, unless otherwise stated.

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Index descriptions

J0A0 - The ICE BofA ML US Cash Pay High Yield Index tracks the performance of US dollar denominated below investment grade corporate debt, currently in a coupon paying period that is publicly issued in the US domestic market.

C0A0 - The ICE BofA ML US Corporate Index tracks the performance of US dollar denominated investment grade corporate debt publicly issued in the US domestic market.

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