What To Do With Credit When Employment Has A Yellow Light by Eric Basmajian


  • Corporate credit has been rallying strongly for the past several weeks.
  • Investment grade corporate bond spreads are near the tightest level in 20 years.
  • The labor market is flashing a yellow light.
  • Investment grade corporate bonds make sense in a balanced portfolio.
  • Given the worsening employment data and the historically tight credit spreads, an overweight position in corporate credit carries heightened risks.
  • Looking for a helping hand in the market? Members of EPB Macro Research get exclusive ideas and guidance to navigate any climate. Get started today »

What To Do With Credit When Employment Has A Yellow Light

Investment-grade corporate bonds had a stellar year, rising more than 17% throughout 2019, based on the total return of Corporate Bond ETF (LQD). Investment-grade corporate bonds certainly have a spot in a balanced portfolio, in addition to less risky Treasury bonds.

Historically, when economic growth is decelerating, corporate bond spreads generally rise or "widen." Conversely, when economic growth is accelerating, corporate bond spreads fall or compress.

As such, when economic growth is decelerating, it is prudent to have an underweight exposure or no exposure to investment-grade bonds as most of the return will come with less risk by owning Treasury bonds. When economic growth is accelerating, tightening corporate bond spreads can offset the expected increase in bond yields that comes with stronger rates of growth.

Based on a continued deceleration in the rate of economic growth, the remaining economic cycle risks (specifically employment), and with credit spreads already at historically tight levels, an overweight position in corporate credit seems less than prudent.

Corporate Bonds: Is The Reward Worth The Risk?

As we analyze corporate bonds and ETF LQD, we must look at two components, the Treasury yield, and the corporate bond spread.

Secondly, the following analysis takes into consideration a multi-quarter view rather than a short-term trading opportunity and does not discuss hedging interest rate exposure. We are looking at the total return.

Let's rewind the clock two years to the most recent inflection in global economic growth.

In early 2018, leading indicators of economic growth had started to decelerate, but coincident economic data was roaring, and global stock markets made new highs in unison. Investment-grade credit spreads made a fresh cyclical low at the end of January before risk assets tumbled in February.

At the end of Q1 2018, it was abundantly clear based on a variety of leading indicators that US economic growth was going to decelerate. Corporate bond spreads responded by widening through Q4 of 2018, saved by a sharp pivot in monetary policy.

Since January 2019, in addition to Treasury yields falling, corporate spreads have been compressing, a double dose of fuel for investment-grade corporate bonds.

US Corporate BBB Option-Adjusted Spread:

Source: Bloomberg, EPB Macro Research

The investment-grade corporate bond "Quality Spread," or the difference between A-rated spreads and BBB-rated spreads, shows a similar story. Since the inflection in growth, the quality spread has generally been in a trend of widening, respecting the deceleration in economic growth.

Over the past several months, the past several weeks more specifically, spreads have compressed notably, without a corresponding improvement in economic data.

US Investment Grade Quality Spread:

Source: Bloomberg, EPB Macro Research

The investment-grade quality spread is showing more optimism than the high-yield quality spread (CCC OAS - BB OAS), which remains in a bearish trend, more consistent with the empirical trend in economic growth.

US High Yield Quality Spread:

Source: Bloomberg, EPB Macro Research

As noted earlier, corporate bond spreads track the economic cycle with an inverse relationship. In other words, when economic growth is decelerating, spreads widen.

The chart below shows the US ISM Manufacturing PMI, a highly useful proxy for the cyclical trend in economic growth, and the Bloomberg Barclays US AGG Corporate Bond OAS (inverted).

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