U.S. Credit: Less Stress than Meets the Eye

Mid Week Bond Update

U.S. Credit: Less Stress than Meets the Eye

The credit cycle has further to run, according to key signs within the credit sector.

With nominal interest rates at record lows, inflation stubbornly below the Fed’s target, and the U.S. yield curve flirting with inversion it’s no wonder that the potential for recession is a serious concern for bond investors.

Historically, credit markets are where signs of economic stress can be seen most clearly. Yet, credit markets aren’t signaling the same level of stress as macroeconomic data. It’s worth diving into the details to see why the disparity exists.

U.S. High Yield versus Investment Grade Option-Adjusted Spread

Chart Courtesy of Brandywine Global. Source: Bloomberg, Bank of America Merrill Lynch, Brandywine Global. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Brandywine Global’s Brian Kloss observes that the two key indicators (defaults and valuations), suggest we are indeed in the late stages of the credit cycle. -- but that it is still not close to the end, and with opportunities still to be found.

Of special interest now is the relative value between investment-grade and high-yield credit. Though both sectors appear fully valued on their own, the difference in spreads between the two is at the lower end of the historic range, suggesting credit investors could benefit by taking a relatively defensive stance in the high-yield sector, which would be available at a smaller premium than is often the case. Additional opportunities are also possible via security selection in the lower-grade segments of the high-yield sector, as well as in select emerging-market debt.

On the rise: Calls for fiscal stimulus

Many of the world’s major central banks are redoubling their efforts to generate inflation by cutting rates and restarting quantitative easing – so far, to little avail. But the U.S. seems to be having some success at keeping growth alive with a combination of an accommodative Federal Reserve and ample government spending. As of the end of August 2019, the U.S. cumulative budget deficit stood at just over $1.06 trillion, nearly 20% higher than the year-ago August. Total Federal government indebtedness stood at $22.61 trillion as of September 23, 2019, about 13% greater than at the beginning of 2017.

A telling example of the growing demand for fiscal solutions is in Germany, whose fiscal conservatism has left it with a record surplus just as a manufacturing slowdown has gone from bad to worse. And the Bank for International Settlements (BIS), long a supporter of tight monetary policy, has joined in. Claudio Borio, head of the BIS monetary and economic department, recently stated: “Should a downturn materialize, monetary policy will need a helping hand, not least from a wise use of fiscal policy in those countries where there is still room for maneuver.”

The interest in joint fiscal/monetary stimulus is even causing some to challenge the long-held belief that central bank independence from fiscal policy is the best prescription for long-term economic health. But however the debate proceeds, the willingness to reconsider long-held beliefs could result in opportunities along with longer-term risks.

On the slide: U.S. consumer confidence

The widely followed Conference Board Consumer Confidence Index posted its biggest drop since the beginning of 2019, reaching a three-month low of 125.1 for July 2019 from a downwardly-revised 134.2 for August 2019. The index, based on a monthly survey of a sample of 5,000 respondents, also showed the share of respondents who say jobs are currently plentiful falling to a three-month low; on the other hand, the share saying jobs are hard to get also fell.

When viewed in the light of 2Q 2019’s personal consumption expenditure growth of 4.7% vs. the previous quarter, it could be argued that U.S. consumers’ behavior doesn’t match their more pessimistic outlook as expressed in this poll. But as a hint of where the next dollar might be spent vs. where the previous dollar went, the results could foreshadow a more challenging time ahead.


The Conference Board (CB) is a member-driven economic think tank. Founded in 1916 this not-for-profit research organization is a widely quoted private source of business intelligence.

The Conference Board Consumer Confidence Index is a barometer of the health of the U.S. economy from the perspective of the consumer. The index is based on consumers’ perceptions of current business and employment conditions, as well as their expectations for six months hence regarding business conditions, employment, and income. The Consumer Confidence Index and its related series are among the earliest sets of economic indicators available each month and are closely watched as leading indicators for the U.S. economy.

The yield curve shows the relationship between yields and maturity dates for a similar class of bond

Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

The Bank for International Settlements (BIS) is an international organization fostering the cooperation of central banks and international monetary policy makers.

An Option-Adjusted Spread (OAS) is a measure of risk that shows credit spreads with adjustments made to neutralize the impact of embedded options. A credit spread is the difference in yield between two different types of fixed income securities with similar maturities.


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High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.