Credit Monitoring Basics: A Must Have Skill
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Since the turn of the year the price of LQD, the investment grade corporate credit ETF, has declined nearly 10 points (-7.3%) and since early August is down 13 points (-10%). The important question is…. Why?
Knowing how to monitor credit is an important skill, particularly since so many in the commentary or advice business so misunderstand it. In this post I want to provide basic tools that will allow you to perform a down and dirty evaluation.
Why is credit so important? The Federal Reserve is much more sensitive to credit distress than they are to equity distress. If companies are unable to secure funding, they may face liquidity problems, and liquidity problems have the potential to become systemic. In 2008 and again in 2020 credit markets were, in essence, frozen. Particularly in 2008, even short term funding markets froze. There were plenty of offers but in many cases no bids. Being an old bond guy, I may be prejudiced, but credit makes the economy go and in general terms is much more important to short term functionality than equity. I think the Fed is more responsive to credit market functionality than it is to equity distress.
Listening to the angst of the want-to-be macro analysts or simply looking at the price of credit ETFs like LQD or HYG might lead one to believe that credit was generating an economic warning or danger sign. That narrative is, at least for now, false.
Corporate bond yield has two primarily components:
• Base rate: In the case of fixed coupon corporates the base rate is the nearest maturity on-the-run (most actively traded) U.S. Treasury (TR). The base rate is generally thought of as the risk free rate.
• Spread to the base rate: The spread above the base rate compensates credit investors for the higher risk of default and downgrade and the wider bid-offer (liquidity) spreads involved in corporate trading.
• For instance: 10 year Treasuries yield 2.00% and a ten year XYZ corporate security is offered at 120 basis points (bps) to TR. All-in-yield for XYZ is 3.20%.
Because there are two primary constituents of a corporate yield, price change can be driven by two things.
• Changes in the base rate. In other words, changes in treasury yields.
• Changes in the credit spread. Spreads widen/narrow to the base rate as investors seek additional/less compensation for default, liquidity and downgrade risk.
Normally the primary driver of changes in corporate ETFs and indices is change in the base rate/treasury yields. Said another way, TR yields are more volatile than corporate spreads.
• Big changes in Treasuries equate to big changes in corporate bond prices.
Chart 1: This is a long term chart of IEF (7-10 year Treasury ETF) plotted with LQD (the investment grade bond ETF).
• You can see how closely the two correlate.
• There will be some difference due to differences in duration (a measure of rate sensitivity) of the index versus the duration of the Treasury and changes in the spread component.
• But, clearly, changes in Treasury rates have an outsized influence on corporate bond rates/prices.
Chart 2: Option adjusted spread of the ICE BofA Investment Grade (IG) and High Yield (HY) Corporate Index's:
• The OAS offers a way to assess the credit spread component of a corporate bonds yield.
• Investment grade index is +1.08% to the base rate.
• High yield spread is +3.44% to the base rate.
○ There is more default risk in high yield, so the compensation, or spread to the base rate, is correspondingly higher than that of IG.
• Both IG and HY spreads remain very near historic lows with very little evidence that credit investors are growing fearful of default, downgrade, or liquidity risk.
Chart 3: All in yield BBB corporate index (top), BBB OAS or credit spread (center) and ten year treasury note yields (bottom).
• The all-in-yield, of the ICE BofA BBB index has risen significantly over the last few months.
○ Remember that in a bond, higher yields equate to lower prices. So a higher all-in-yield means that corporate bond prices are lower.
• BBBs are the lowest rating category of the Investment grade index and are more sensitive to the ebb and flow of default and downgrade risk than the investment grade index as a whole.
• While the all-in-yield has risen sharply over the last few months the OAS has barely budged from support.
Investors are not yet demanding more compensation for default risk. The change in corporate pricing has been driven by the sharp rise in rates.
Bottom Line: To understand the state of the credit market, you have to assess both changes in rate and changes in the spread. Hopefully you now have the tools to do a down and dirty assessment of your own.
Good Trading:
Stewart Taylor, CMT
Chartered Market Technician
Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.
Since the turn of the year the price of LQD, the investment grade corporate credit ETF, has declined nearly 10 points (-7.3%) and since early August is down 13 points (-10%). The important question is…. Why?
Knowing how to monitor credit is an important skill, particularly since so many in the commentary or advice business so misunderstand it. In this post I want to provide basic tools that will allow you to perform a down and dirty evaluation.
Why is credit so important? The Federal Reserve is much more sensitive to credit distress than they are to equity distress. If companies are unable to secure funding, they may face liquidity problems, and liquidity problems have the potential to become systemic. In 2008 and again in 2020 credit markets were, in essence, frozen. Particularly in 2008, even short term funding markets froze. There were plenty of offers but in many cases no bids. Being an old bond guy, I may be prejudiced, but credit makes the economy go and in general terms is much more important to short term functionality than equity. I think the Fed is more responsive to credit market functionality than it is to equity distress.
Listening to the angst of the want-to-be macro analysts or simply looking at the price of credit ETFs like LQD or HYG might lead one to believe that credit was generating an economic warning or danger sign. That narrative is, at least for now, false.
Corporate bond yield has two primarily components:
• Base rate: In the case of fixed coupon corporates the base rate is the nearest maturity on-the-run (most actively traded) U.S. Treasury (TR). The base rate is generally thought of as the risk free rate.
• Spread to the base rate: The spread above the base rate compensates credit investors for the higher risk of default and downgrade and the wider bid-offer (liquidity) spreads involved in corporate trading.
• For instance: 10 year Treasuries yield 2.00% and a ten year XYZ corporate security is offered at 120 basis points (bps) to TR. All-in-yield for XYZ is 3.20%.
Because there are two primary constituents of a corporate yield, price change can be driven by two things.
• Changes in the base rate. In other words, changes in treasury yields.
• Changes in the credit spread. Spreads widen/narrow to the base rate as investors seek additional/less compensation for default, liquidity and downgrade risk.
Normally the primary driver of changes in corporate ETFs and indices is change in the base rate/treasury yields. Said another way, TR yields are more volatile than corporate spreads.
• Big changes in Treasuries equate to big changes in corporate bond prices.
Chart 1: This is a long term chart of IEF (7-10 year Treasury ETF) plotted with LQD (the investment grade bond ETF).
• You can see how closely the two correlate.
• There will be some difference due to differences in duration (a measure of rate sensitivity) of the index versus the duration of the Treasury and changes in the spread component.
• But, clearly, changes in Treasury rates have an outsized influence on corporate bond rates/prices.
Chart 2: Option adjusted spread of the ICE BofA Investment Grade (IG) and High Yield (HY) Corporate Index's:
• The OAS offers a way to assess the credit spread component of a corporate bonds yield.
• Investment grade index is +1.08% to the base rate.
• High yield spread is +3.44% to the base rate.
○ There is more default risk in high yield, so the compensation, or spread to the base rate, is correspondingly higher than that of IG.
• Both IG and HY spreads remain very near historic lows with very little evidence that credit investors are growing fearful of default, downgrade, or liquidity risk.
Chart 3: All in yield BBB corporate index (top), BBB OAS or credit spread (center) and ten year treasury note yields (bottom).
• The all-in-yield, of the ICE BofA BBB index has risen significantly over the last few months.
○ Remember that in a bond, higher yields equate to lower prices. So a higher all-in-yield means that corporate bond prices are lower.
• BBBs are the lowest rating category of the Investment grade index and are more sensitive to the ebb and flow of default and downgrade risk than the investment grade index as a whole.
• While the all-in-yield has risen sharply over the last few months the OAS has barely budged from support.
Investors are not yet demanding more compensation for default risk. The change in corporate pricing has been driven by the sharp rise in rates.
Bottom Line: To understand the state of the credit market, you have to assess both changes in rate and changes in the spread. Hopefully you now have the tools to do a down and dirty assessment of your own.
Good Trading:
Stewart Taylor, CMT
Chartered Market Technician
Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.
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