More corporate bond investors are starting to position themselves for what they are calling the ‘decompression trade’ where the spreads of low rated bonds widen against those with higher credit ratings. But the bond market has shown that it does not care to meet expectations when it comes to spreads.
The spread between low and high risk corporate debt has been grinding tighter since 2020. At the end of last year, the iTraxx Europe Main was 289bp wide of the Crossover. By this week, that difference had tightened to 239bp.
This is not just an esoteric technical development – it is having a tangible impact on primary market activity. In the last few months, it has made some hybrid bonds difficult to sell, because investors were not convinced they were being adequately rewarded for the structural risk of subordinated debt.
Now, more investors are becoming convinced that next year will see spreads between investment grade bonds and sub-investment grade decompress.
The degree of certainty shadows that at the start of 2024. In January, there was widespread belief that all corporate credit spreads would widen, with many investors reckoning by at least 20%. This, of course, did not happen, with high grade spreads now 12bp tighter than they were in the first week of January.
Meanwhile, high yield, high beta and subordinated debt should have been inching – if not leaping – wider this year, with high levels of economic uncertainty in Europe, still high interest rates, and increased default rates.
But they didn’t, because money kept pouring into corporate credit funds and investors had to put it somewhere.
That they are trading so close to top end investment grade yields now suggests that, despite many investors saying decompression is coming, even more think they are being adequately rewarded for the risk they are taking on.
It makes sense for decompression to happen next year. There is little logic in cyclical sectors trading so close to defensive sectors, or in riskier debt trading close to debt that is almost guaranteed never to default.
But just because it makes sense, doesn’t mean it will happen. Do not be surprised if the spread between IG and high yield remains where it is, or, if fresh money keeps coming into corporate credit, it tightens even further.