The charts
Relative to riskier areas, valuations in credit-market segments that are higher rated and more defensive are historically compelling, following an extended period of ‘spread compression’.
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Ratio of high-yield to investment-grade spreads
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Ratio of cyclical to defensive sector spreads
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Source: BofA, Ninety One, October 2024. EU high-yield and EU investment-grade government OAS spreads are from BofA indices. Cyclicals includes basic industry, energy, automotives, retail and transport. Defensive includes utilities and telecoms.
The context
Since 2020, credit spreads – the compensation investors earn for taking on additional credit risk – have compressed significantly. As shown in the charts, this can be seen through a variety of lenses. From a credit-rating perspective, the ratio of high-yield to investment-grade spreads in Europe is near its lowest point in 20 years (currently 3.2x compared to a peak of 4.2x in 2020 and 8.6x in 2005). From a sector perspective, the difference between spreads in cyclical and defensive sectors is also near historical lows (currently investors can earn the same spread in defensives as cyclicals). Looking ahead, it appears likely that spread decompression will take place between lower-quality parts of the market and their higher-quality counterparts, regardless of whether the prevailing investment backdrop is risk-on (spreads tightening) or risk-off (spreads widening). In effect, the compression seen in the past year could reverse.
To explain: many parts of the high-yield market are nearing their so-called ‘spread floor’, i.e., they provide investors with little more than the bare minimum amount of compensation for their exposure to default risk; this leaves limited room for further spread compression, even in a risk-on environment. From a sector perspective, the riskier parts of the credit market also look relatively vulnerable in the event of risk-off environment, as cyclical sectors typically underperform defensives (credit spreads widen more in cyclical sectors more than in defensive sectors) against such a backdrop.
Crucially, at current spread levels, investors can strengthen their portfolio defences without sacrificing much in terms of income. For instance, bonds issued by companies in Europe’s utilities sector (a classic ‘defensive’ sector that is typically very resilient in economic downturns) today pay investors an attractive level of spread. This is particularly relevant given the uncertain macroeconomic outlook in Europe.
The conclusion
Significant spread compression has taken place in credit markets since 2020. This has created a rare opportunity for flexible investors to shift their portfolios to a more defensive stance without sacrificing much in the way of income that – in ‘normal’ circumstances – higher-risk market segments typically provide.
Favouring more defensive parts of the market also appears a prudent option given the likelihood of a reversal of moves seen over the past year, i.e., in the event of spreads decompressing.
