The Tail Risk In Credit Markets

In my career as a money manager I never traded credit products, but I was taught to watch them closely for early warnings of general market trouble. The story was that credit investors worry about mitigating losses while equity investors care more about potential upside. Impending bad times for the economy are therefore priced into corporate bonds before equity markets catch on.

The Covid crash of March 2020, and more specifically the Fed’s support of the corporate bond market that followed, seems to have changed that. During the initial phase of the crisis corporate bonds performed horribly as investors rushed out of bond ETFs and money market funds that they had been holding as cash substitutes.

This exit severed a critical chain in the financial ecosystem. Companies issue bonds, using part of the funds to buy back shares. The bonds are packaged into funds or ETFs which are then held by investors looking for alternatives to zero-yielding deposits and Treasury bills. Normally, investors can buy or sell these funds freely and they therefore come to be seen as “good as cash”.

Shadow Bank Runs

Until a crisis hits. Then the default risk in the funds is recognized and there is a flight back to real cash. Companies needing to roll-over debt can’t find buyers and a critical source of demand for equities – stock buybacks – disappears. If this sounds like a bank run, it is, but it’s a modern form that keeps reinventing itself in new shapes.

In 2020, faced with this shadow bank run, the Fed announced it would buy corporate bonds and bond ETFs. Yield spreads on corporate bonds relative to US Treasuries fell, and kept on falling. By the summer of 2021 spreads on BBB corporate bonds, the lowest level of investment grade and where the bulk of recent issuance has been, were close to the tightest on record. Meanwhile, implied volatility on the S&P 500 – probably the most important global measure of risk – stayed elevated.

That’s very unusual. After a crisis the VIX normally subsides faster as equity markets get back to thinking about making money while stodgy bond investors take more convincing. Now, triggered by the Russian invasion of Ukraine, the VIX is again elevated. But BBB corporate bond yields have barely moved. Yes, the BBB yield spread has widened somewhat, but that’s due to the fall in US Treasury bond yields, not any sense of worry with corporate bond investors.

Equity Markets Are Nervous. Credit, Not So Much.

Relative to its full history the VIX is now around the 88th percentile. In other words, it’s only been higher than current levels about 12% of the time. I looked at where credit spreads were on days where the VIX was at or above its current percentile rank and plotted them out on the graph below. The tiny slivers of orange on the far left represent where we are now. In the past, when equity risk was this high, credit markets were worried. No longer.

What this tells me is that the corporate bond market takes the Fed’s previous support very seriously. If the current crisis deepens and markets become unsettled to the point where Fed intervention is needed, corporate bonds expect to be part of the support package. If you don’t think the Fed will do this, then there is some serious tail risk in corporate bonds right now.

Safe Haven?

It’s also interesting to watch the rally in U.S. Treasury bonds. In 2008 and 2020 it was challenging to disentangle the factors that were driving bond returns. Were U.S. Treasuries going up in value and yields falling because investors were worried about deflation? Or was the rally driven by their perceived safe-haven status? This time around it’s very clear. Inflation is already at 30-year highs and, with the Fed now expected to tighten policy more slowly, it risks rising even more. The rally we have seen in US Treasures is solely due to their safe-haven appeal.

Again, though, this feels shaky. Sure, if the conflict in Ukraine escalates into a bigger war, then safe haven concerns will dominate. But inflation is ultimately the enemy of bond returns, so holding bonds as a safe haven seems increasingly contradictory. I’m no expert on gold, but given these fundamentals its recent rally might be sustainable.