Opinion Derivatives

Kelley Baum

Historically, high yield credit markets have moved approximately one-for-one with equity markets in major sell-offs. However, over the past few months, high yield has only sold off by around half of the equity move.

Real money investors like credit

Furthermore, balance sheets look robust and corporate cash balances are near record high levels, while net issuance in US high yield credit has been close to zero over the past two years.

In addition to looking at higher yields and corporate fundamentals, focusing on the move in real rates is key to the story. The sell-off in real rates has coincided with a significant price-to-earnings multiple contraction in the S&P.

Real rates and equity multiples have followed a close relationship historically, and as 10-year real rates rose from close to -1.4% to almost +0.6% from late 2021 to mid-2022, S&P multiples contracted from around 22x to around 16x.

Of course, earnings projections have remained largely stable so far — the equity sell-off has been driven by multiple contractions rather than poor earnings or lower earnings projections. But if earnings weaken, equity and credit markets could enter a new phase in the sell-off.

Credit spreads are sensitive to earnings, as the risk premium demanded in credit spreads is closely tied to default-rate expectations. But default-rate projections have remained benign, for the most part. Some banks predict that 2023 default rates will be under 2%. However, one bank has taken a dire view on upcoming US high yield defaults, raising expectations to around 6% in 2023 and 10% in 2024.

A nuance to the earnings question is whether nominal earnings can grow while real earnings fall. This scenario might be difficult for equities, which are focused on real earnings, but fine for credit, where higher nominal earnings can still lead to lower overall leverage (and thus limited change in default rates, especially if near-term maturities have already been pushed out so corporates are not facing a refinancing wall at higher rates).

Credit dispersion can only increase

How will credit perform relative to other asset classes (especially equities) in the coming months? Will credit markets be a safer place to hide out through this turmoil, or should investors shift equity hedges into credit given the compelling relative entry?

Sequencing matters here — equity markets tend to trough three-to-six months before earnings. So it’s possible credit markets will see additional weakness as earnings reprice lower.

In addition, credit dispersion trades may be valuable positions as certain companies are better suited to withstand the pressures of inflation compared with others. And for those with a more negative view on the trajectory for earnings, US HY cash credit still looks like a compelling market in which to set hedges.