RISK-TAKING HAS CRUSHED SPREADS

FINANCIAL MARKET ANALYSIS

Bond market performance has been disappointing overall since 1st January. The resilience of the US economy and the slower-than-expected deceleration in inflation have led investors to fear that central banks will not be able to cut their key interest rates as early as March. Market expectations are now that the Fed, as well as the ECB and the SNB, will ease monetary policy in June. This postponement of a cut in short-term rates has had repercussions across the entire yield curve, from 3 months to 30 years, and on most issuers, both governments and corporates. Returns on investment ranged from -6.7% for 30-year US Treasury bonds to +1.6% for the lowest-rated bonds issued by emerging corporates (see Figs. 2 & 3).

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Since investors are convinced that bond yields will eventually fall, they are willing to take on more risk. Their primary objective is to take advantage of the highest yields (see Chart of the Week), in the knowledge that such opportunities may no longer be available in a few quarters' time. In other words, they assume that the coming fall in interest rates will compensate for any increase in credit spreads and favour high-yield bonds.

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Spreads between corporate bond yields and US Treasuries have reached extremely low levels (see Fig. 4). This is somewhat less the case in Europe, although the contraction is also marked (see Fig. 5). For the record, spreads reflect investor confidence. They quantify the extra yield required by buyers to move into riskier assets and give up the safest financial instruments, assuming that the risk of default by the US government is considered to be the lowest. The yield spread on US high-yield corporate bonds, a benchmark commonly used to gauge this perception of risk, fell to 351 basis points, its lowest level since January 2022. The move is even more impressive for investment grade corporates, with 'single A' rated bonds now offering a premium of just 61 basis points, their lowest level ever. Normally, credit spreads are low when financial conditions are easy and corporate defaults are minimal. Paradoxically, this is not the case at present (see Figs. 6 & 7).

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Unless anyone believes that investment-grade corporates are now only slightly riskier than US sovereign debt, the optimism of bond investors seems exaggerated. Between 14 and 21 February, investors poured $15 billion into bonds, including $10 billion into investment-grade fixed income funds. This marked the sixteenth consecutive week of inflows, the longest sequence since October 2021.

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This risk-taking on the bond market, which to some may seem like recklessness, has been encouraged by the strong performance of the stock markets. The S&P 500 has just hit a new record high of USD 5,111. With the exception of the Covid-19 period, between 2020 and 2022, credit spreads have always moved in tandem with equity performance and volatility (see Figs. 8 & 9). All three indicators react similarly to changes in economic and financial conditions. To keep US spreads so low, the annual performance of the S&P 500 will have to continue to exceed 15%. Otherwise, buying equity volatility will be a very effective way for investors to hedge their portfolios, not only against a future stock market correction, but also against an increase in credit risk.

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Conclusion:

Given market conditions, investors are rational in seeking to increase their allocation to fixed income assets. However, in terms of risk-adjusted return, sovereign bonds currently have a clear advantage over corporate bonds. If spreads widen, those who have bought equity volatility will also be better hedged.

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RETURN ON FINANCIAL ASSETS