US High Yield debt: One less financial stress factor to worry about
The recent rise in oil prices helped High Yield debt to start a rally, which is reassuring.
Yield spreads between High Yield (HY) and Sovereign debt widened significantly at the end of 2018 in the US, from 313bp to 540bp, representing a rise of 227bp in the space of two months! This movement reflected investors' stress about a slowdown in global growth (the word "recession" was often mentioned). If this risk had materialised, it would have led to a decline in corporate profits and even bankruptcy for the most vulnerable among them. Spreads therefore widened as investors sought a higher remuneration to compensate for the higher risk.
The perception of risk has improved since the beginning of the year thanks to the rebound in oil prices and the change in rhetoric of central banks, with the Federal Reserve leading the way. At the end of last year, it was planning more rate hikes, but is now arguing for a pause. The markets are even going a step further. They are no longer pricing in any rate hikes this year and are expecting the beginning of a new rate cut cycle next year. HY spreads have thus narrowed rapidly (-126bp in one and a half months) and investors’ risk appetite has returned.
As the vast majority of economists at banks and financial institutions (IMF, European Commission) have revised down their growth projections, it is important to watch HY debt closely especially as it is one of the stress indicators in the markets. Historically, a rapid widening of HY spreads is often followed by a fall in equity markets.
More specifically, we are following the difference between the US HY spread and the US Investment Grade (IG) debt spread. This spread is a better reflection of investors' perception of credit risk. A difference of 2 standard deviations from the moving average is a danger signal. This was the case last December, but has not been since early January. The reason? The rebound in oil prices. Indeed the price of a barrel of oil peaked at $76 in October 2018 before falling to $43 at the end of December in the context of an economic slowdown. It has since picked up and is now at around $54.
The spread on US HY debt started to contract a few days after the rise in oil prices. The correlation is pretty logical because approximately 15% of HY issuers are oil companies. However, it is reassuring to see this correlation because it proves that the market did not blindly become a sellers' market at the end of last year. It would have been a real concern to see the HY spread continue to widen at the beginning of this year despite the rise in oil prices. In a nutshell, it’s one less financial stress factor to worry about.