As of December 10, the U.S. credit option-adjusted spread is at 99 basis points (bps) and on track to end the year close to the same level where it was at the start of 2020. It’s been quite a ride, with year-to-date spread-widening of under 10 bps doing no justice to the volatility experienced over the last few quarters. Ironically, if you closed your eyes on New Year’s Eve 2019 and looked at the market for the first time today, you might be compelled to use the word “boring” to describe 2020, when it has been exactly the opposite.
Not surprisingly, corporate fundamentals have deteriorated over the course of the year but are expected to improve. Companies are adjusting their strategies to the post-COVID-19 operating environment, and outcomes in 2021 are likely to be divergent. An improvement in fundamentals in the coming year without the shock of a global pandemic and anticipation of a vaccine is partly a driver of market behavior, but something else is afoot.
While this year has been remarkable in several ways for IG credit, the most impressive trend has undoubtedly been the outsized demand for corporates. In reaction to March’s pandemic driven selloff, the market healing process was jumpstarted by the central banks, their primary and secondary market lending facilities and, subsequently, their various secondary market purchase programs, which stabilized market plumbing and brought front-end funding costs in check. With an OAS of 95 bps, we admittedly don’t need the Fed at this point. But that backstop has now become implied, rightly or wrongly. The market cannot unsee these actions; the precedent has been set.
The heart of the rally coincided with the search for yield, as we saw north of 100 bps evaporate off U.S. 10-year yields from mid-February to mid-March (not to mention the current record amount of negative-yielding debt). In these latter stages, this technical euphoria is ongoing as hedging costs to overseas investors are at around the most attractive levels we’ve seen in the past five years. Finally, while supply has been off the charts in 2020, it’s expected to normalize next year.
As we approach year-end with supply and liquidity drying up, it is always possible that spreads could move wider. Analyzing that risk is at the crux of what we do. With 2020 grinding to a close, we think that spreads could do precisely the same.