If anyone was out of the office during the end of last week, they would have missed an epic three-day rally (May 25 to 27) in U.S. high yield (USHY) credit spreads. For most of May, USHY credit spreads had been widening materially. At their widest, these spreads reached almost 100 basis points (bps) higher than where they stood at the start of the month.
The unrelenting widening in credit spreads had felt like a continuation and acceleration of the risks and fears being priced into credit spreads from the start of the year. This was justified because much had changed — there is now a horrific war in Ukraine, the Federal Reserve (Fed) has started a hiking cycle to combat inflation, supply chain and logistics continue to drive costs and inflation higher, many equity markets entered into bear markets (-20%) as risk assets have repriced and we are about to embark on the Fed’s quantitative tightening (QT) cycle.
With all of this (and more) as the backdrop, it is no wonder that USHY credit spreads would be higher. Interestingly, over the past 12 years, the U.S. high-yield market has had six prior stretches of material spread widening over approximately six-week periods. The magnitude of the recent six-week stretch of high yield spread widening (+153 bps) has been exceeded six other times since 2010.
In this week’s chart, we can see that in all of the six prior bouts of material spread widening, USHY has performed very well in the subsequent three months. According to J.P. Morgan Credit Research, the average tightening (ex-pandemic) equated to 11% of ending period spreads (which would be about 58 bps in today’s spread). During the three-day rally (May 25 to 27), the spread tightening has already exceeded that average move and is 62 bps tighter. This begs the question — where do we go next?
It’s important to note that during all six prior periods of material spread widening, USHY spreads were wider than the May 2022 level. Moreover, in all of these cases, the spreads also ended wider than the last 12-year USHY average spread of 533 bps. This time, spreads did get to 537 bps, but were still the tightest of the seven six-week periods of spread widening. Additionally, this most recent time in May was also the least severe spread widening (+153 bps vs. an average of approximately +204 bps ex-pandemic).
Importantly, during each of those prior bouts, the Fed was still in its easing cycle and/or had the ability to provide that relief to the market — while this time, the Fed must continue to fight inflation and that Fed put should not be expected. Couple the current hiking cycle with the capital expected to come out of markets and the economy through upcoming QT, and this rapid spread tightening in USHY may ultimately be short-lived.
Key Takeaway
The USHY market has historically performed well after material spread widening that occurred over six-week periods. During the three-day rally (May 25 to 27), the USHY market has already exceeded the average percentage spread tightening that prior markets have experienced in the subsequent three-month period.
The epic USHY rally clearly could continue, but ultimately it feels like spreads should justifiably be wider given all of the material macro risks. This time, it’s different for two main reasons — lack of a Fed backstop and embarking on QT. The USHY technical backdrop seemingly has been supportive, as demonstrated by this three-day market rally.
I would now expect the primary market to open up again and initial deals should come at nice discounts to the market. No one knows where the market will go next, but I would not be surprised if current spreads once again prove too tight and USHY credit spreads retrace wider, providing an even better entry point into the asset class.
Index Definition:
The J.P. Morgan Domestic High Yield Index is designed to mirror the investable universe of the U.S. dollar domestic high-yield corporate debt market, including issues of US and Canadian domiciled issuers. The Domestic Index is a subset of the J.P. Morgan Global High Yield Index.
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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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