Credit managers have been suffering for years now. Yeah, I know that sounds strange given the run credit markets have had. But the truth is they’ve been suffering from sticker shock since 2011. “But what can I buy at these levels?” has been their constant refrain. Many have been underperforming their benchmarks and bogeys for years.
How did they fall into this trap? Start with the chart of the BBB spread over the last 15 years.
Credit managers have anchored on spread levels and yields from the strong phase of the last risk cycle, 2004-2007. Spreads then were 110-130bps. Today they are 138bps. Five-year BBB yields then were 5-6%, whereas today they are 3-3.5%. Credit managers have been forced into chasing yields lower and lower for the last 5 years.
What they’ve been overlooking is the risk free rate. The 5 year risk free rate averaged around 4% from 2004-2007, and now we are at 1.8%. If you look at how much risk-free yield (opportunity cost) you are giving up to collect extra spread, it becomes obvious that a spread of 138bps is far, far cheaper when the risk free rate is at 1.8% than when it is 4%. Spread-to-spread comparisons just don’t make sense. Yet that’s what we keep hearing. It’s kind of shocking, really, how many professional managers–especially those with a lot of experience, paradoxically–have been blinded to this simple but powerful consideration.
The TL;DR: Credit markets aren’t as rich as you might have thought, and in any event, the credit cycle is likely to end around the time the economic cycle in the US turns, irrespective of valuations.