The credit-market bears may well be vindicated if the US enters a recession in the next year, but it’s too early to go full-scale Armageddon with predictions about corporate bond spreads.
In their baseline scenario,(1)Moody’s Investors Service analysts led by Sharon Ou forecast that default rates will continue ticking higher from here but remain below the 39-year historical average through at least August 2023. Meanwhile, a Bloomberg measure of bankruptcy activity hit the lowest level on record earlier in the year and has inched up only slightly. Credit spread blowouts tend to occur when large-scale bankruptcies are actually on the economy’s doorstep, not in anticipation of events that may be almost a year in the future.(2)
In that sense, the corporate bond market finds itself in much the same no man’s land as the rest of the US economy. Predictions of a looming recession still have to be balanced against the near-record low unemployment rate and manageable debt service ratios. And the US consumer, the engine of the American economy, still looks resilient, which should buttress growth and corporate earnings.
What’s less clear is whether those advantages will blunt the impact of a recession altogether; delay the downturn by a few quarters; or, on the flip side, prompt Federal Reserve Chair Jerome Powell to dig in his heels, pushing interest rates higher and higher to curb the worst inflation in 40 years. After all, monetary policy typically works by intentionally reining in demand, so any resilience may simply be met with a more powerful central bank response.
Clearly, the same facts can yield much different predictions, and many investors find themselves trying to strike a balance. The median projection in a Bloomberg survey of economists still shows even odds that the US will enter a recession in the next 12 months, and those probabilities have held constant since August, notwithstanding the sharp souring of market sentiment that’s taken place in interim.
If you agree that a near-term recession is essentially a coin flip, market pricing of credit risk looks surprisingly sensible. As I wrote last month, a fairly shallow recession would probably mean an 800-basis-point option-adjusted spread on US high-yield debt, while a non-recessionary bull case might compress the spread to 325 points. Assuming economists’ 50% recession odds, it seemed reasonable to split the difference and pencil in a fair value spread of around 563 basis points for now. At the current 548 basis points, the market is right in that general vicinity.
Could spreads bounce around in that range in the short term? Certainly. Spreads will continue to track stock-market volatility, which will in turn be driven by the macroeconomic tea leaves and the utterances of central bankers. Traders will choose a direction at some point as the facts on the ground change more concretely, but this doesn’t feel crazy for now — far from it.
Needless to say, none of that nullifies the bear case. Credit markets have also changed drastically since the financial crisis, and it’s conceivable that the real signs of distress are hiding in more opaque private credit markets. But as far as high-yield bonds are concerned, it appears that investors can stop giving the market so much flak(3) for being indifferent about recession risk. That may have been true earlier in the year, but current pricing hardly feels that detached from reality. Bears may yet have their “told you so” moment, but they’re likely to be waiting awhile.
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(1) The baseline scenario from their Sept. 19 “August 2022 Default Report” assumes US unemployment reaches 4.1% by August 2023. Under their moderately pessimistic and severely pessimistic scenarios, Moody’s has unemployment spiking and the 12-month global speculative-grade default rate well-exceeding the 1983-2021 average, potentially passing that guidepost sometime late this year.
(2) Certainly, the situation could deteriorate faster than that if something “breaks” and the economy’s slow-motion deceleration accelerates to a collapse. It’s not clear what might break, but the bears have plenty of risks to point to, including the war in Ukraine and the cooling demand from both China and Europe.
(3) I was certainly one of the critics in August after spreads narrowed to just 407 basis points.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Jonathan Levin has worked as a Bloomberg journalist in Latin America and the U.S., covering finance, markets and M&A. Most recently, he has served as the company’s Miami bureau chief. He is a CFA charterholder.
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