Don't look back

Credit markets: Credit investors should savour memories of the last nine months of 2009. Such good times aren’t likely to come again soon.

It was a golden age. A flood of funds kept government bond yields low while renewed economic confidence reduced fears of widespread corporate collapses. The result: the spread on the Markit iTraxx Europe index, a measure of yield on investment-grade debt, dropped from over 200 basis points in March to less than 80 basis points by December.

That’s still relatively high by historical standards, so some further narrowing is possible. To get there, credit investors need GDP growth to stay low enough that central bankers keep monetary conditions easy but high enough to keep panic away. Yield-hungry investors would buy corporate debt, pushing down spreads.

That is a difficult equilibrium to maintain. If growth picks up, the spread over government debt might narrow as the risk of default receded. But the yield on government debt would probably rise as monetary stimulus disappeared and inflation fears increased. A sharp recovery could also spark an exodus from credit into equities, which are even riskier and better shielded from inflation. Alternatively, the recovery might recede into stagnation or a renewed recession. That would probably keep government debt yields low, but bring many more companies close to the brink.

SO spreads would widen, bringing losses to credit investors. There’s an even worse scenario. Suppose governments respond to a persistently weak economy by issuing even more debt, but investors are reluctant to buy. That would push up government bond yields while companies would still be struggling. That combination would wreak havoc in almost all financial markets, including credit.

What should a credit investor do? Well, fearful types should go for short maturities and highly rated issuers. But for those willing to take on some risk, there’s still potential in the high yield market. At 440 basis points in late December, the iTraxx Crossover of mostly junk-rated companies is still over 200 basis points higher than its tightest point in 2007.