As Russia, Fed Send Stern Signals, Let's Decode the Credit Market

The credit market has been very weak to start 2022, battered by dual uncertainties about the impact of policy tightening by the Federal Reserve and the prospect of war in Ukraine. So far this year high-yield bond spreads have moved 77-basis points higher, retracing all the gains from 2021. But not all credit selloffs are created equal, and interpreting what the corporate bond market is telling us requires some nuanced analysis. Here's my take on what it does and does not mean for investors. Do Credit Investors Have an Edge? You've probably heard analysts say that the credit markets do a better job of predicting recessions than the equity market does. There's truth to this, but it isn't because credit traders are smarter than anyone else. It's because in most types of credit have limited upside in a positive outcome, but large downside in a negative outcome. So people who trade in credit put much more emphasis on tail risks than other types of investors do. An equity trader might look at a tail risk such as the war in Ukraine and think sure there's downside, but if this risk fades, there's also upside. The credit investor focuses almost solely on the downside. This helps explain why credit is now at the worst levels for the year, whereas the S&P 500 has only retraced back to September. Credit investors are more acutely focused on downside risks. Few Sellers, Few Buyers There are two big categories of credit investors: real money (which includes mutual funds, pensions, endowments) and fast money (hedge funds and other levered players). Real money deals mostly in cash bonds, such as real bonds with coupons and maturities, whereas fast money may deal in cash bonds but also heavily uses exchange-traded funds and derivatives like the Credit Default Swap Index credit index contracts. By the way, you may think of ETFs as a retail product, but this is not true in the credit world at all. Large institutional traders have started using credit ETFs heavily in recent years as liquidity has become more consistent in that space than other options. A quick look at volume across these different categories shows what is driving this credit selloff. I compared the average daily trading volume of each of the following between the fourth quarter of 2021 (excluding the weeks of Christmas and New Years) vs. February 2022 (according to data from TRACE, iShares, ICE): Investment-grade cash bonds: up 9% in February vs. 4Q 2021 High-yield cash bonds: up 2% iShares HYG ETF : up 59% Current high-yield CDX contract: up 62% What we see is that cash trading in investment-grade is slightly elevated, probably because of mutual funds dealing with outflows. High-yield cash trading is basically the same though, which would be strange if those investors were actually worried about their positions. On the other hand, the products dominated by fast money trading, the ETF and the CDX are way up. That's who is driving this selloff. Products dominated by fast money trading, the ETF and the CDX are driving this selloff, but the good news is that the lack of real bond selling indicates that this isn't a panicked market. The good news is that the lack of real bond selling indicates that this isn't a panicked market. I'd say that bond market isn't telling us anything that isn't also evident by looking at stocks. Furthermore, the degree of credit selloff to date tells the same story as how interest rates have moved in recent months, namely that bond traders think that the Fed can only hike so much before causing problems for the real economy. Credit has sold off to account for the risk of a Fed mistake. Fed Really Cares About Credit The Fed puts more weight on credit spreads than it puts on stock prices. There are two big reasons for this. First, companies do bond deals all the time. There are billions in new bond issuances every week. Whereas companies actually selling new equity is episodic. In other words, the cost of debt financing impacts the day-to-day functioning of the real economy, whereas the equity market really doesn't. Related, when a company needs to sell new bonds but can't because of market conditions, that has severe consequences. Most new bond deals are done to roll over old debts. If a company can't roll over debts, it may very well end up bankrupt. Obviously that has major real economy consequences. On this score, the Fed probably isn't too worried about credit markets. Investment-grade companies have not had trouble selling new bonds in recent weeks. Some large deals that are on the very bottom rungs of investment-grade have come and been very well subscribed. Admittedly high-yield issuance has slowed the last two weeks, but that's common under this kind of volatility. Bankers will tell issuers to hold off on doing their deal for a couple weeks to see if the market calms down. But the deals that have been sold have also been well-subscribed. I don't think the credit market selloff year-to-date will influence the Fed's decisions. It is possible that uncertainty around Ukraine is enough to result in a quarter-point hike instead of a half-point hike, but I don't think the credit markets themselves will make a difference either way. Finding an Entry Point I'm not adding to credit beta in my strategies here, despite what's happening. Credit is a momentum market, and as such I find it easier to make an entry when spreads seem to have peaked and are headed tighter. When credit spreads are widening, they tend to move wider quickly, as has been the case so far in 2022. When they tighten, it tends to happen slowly. In other words, credit follows the idiom climbing the wall of worry. Given that, I have had more success waiting until it looks like momentum has turned positive than I have had trying to call the bottom. But if you don't want to trade credit and want an entry where you can buy and hold an ETF or mutual fund, this is a perfectly fine entry. The basic fundamentals of the economy are good, and overall yields are as high as they've been since mid-2020. I think an investor with a long time horizon will not regret buying here.

As Russia, Fed Send Stern Signals, Let's Decode the Credit Market

The credit market is on weak footing so far in 2022. Here's my take what's driving the selling and why not all selloffs are the same, why there's no panic and how to find an entry point.

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