Widening credit spreads are typically “an early sign of distress” according to former Future Fund head, Mark Burgess. Speaking at a breakfast in Melbourne for active bond fund manager Jamison Coote Bonds, where he now sits on the advisory committee, Mr Burgess said spreads recently had been widening and that this should be watched very closely by those interested in where markets are heading in the next few years. And this means most of us, according to Mr Burgess, because unlike many other nations, Australia’s mandated superannuation system has made us a nation of investors.
Credit spreads represent the difference between the interest rate that corporations borrow money at and the government bond rate or the relevant swap rate. The highest rated companies borrow at a very low margin over a similar maturity government bond (the so-called ‘risk free’ rate) and this is where company credit ratings can be useful. AAA rated companies borrow at lower rates than a BBB rated company as they are deemed to be less risky. In the chart below it can be seen that the spread over government bonds is highest for BBB rated companies. Below a BBB credit rating a company’s debt is said to be non-investment grade or ‘junk’.
When economic conditions are good credit spreads tend to narrow as investors feel more confident that the company is able to repay its debt. When investors get nervous, credit spreads are one of the first places that feel the effects and that is why they are worth watching.
The chart below shows how credit spreads blew out during the GFC as investors feared company defaults. Prior to the GFC, spreads were at trading in a very tight range at very low levels. Investors were not worried about credit defaults and risk generally was being mispriced. Since the GFC, credit spreads have moved lower although there have been several bumps along the way. With the unprecedented amounts of quantitative easing by central banks, all major asset classes have seen strong buying with sovereign debt, in particular, trading at record low levels.
More recently there has been a widening of credit spreads as investors begin to fret about the US raising interest rates, a slowdown in China and resulting volatile markets, a plunge in commodity prices and the overall effect all of this this may have on the creditworthiness of companies. There have been some major hiccups with Volkswagen in Germany, Glencore in Switzerland and Petrobras in Brazil and these are unlikely to be the only ones.