Are credit spreads too tight?

Many market pundits are talking about credit spreads being too tight, but are they really? If one looks at the various credit indices it’s hard not to say that spreads are too tight. Optically the indices suggest spreads are tight but are they really?

When comparing indices, it’s important to understand how the indices are composed and change over time and how the financial environment has changed over time. For example, the Ausbond All Maturities Index has seen its credit quality change from where credit was approximately 15% prior to the GFC to one now with a credit exposure of approximately 30%. The Government remains the major issuer, however the next cohort of larger issuers the semi-governments have seen their ratings slip. Duration has also moved from pre-GFC levels of 4.5 years to 7 years. That shift has been influenced by longer dated Government issuance. For example, 10 years ago, the Government did not issue 30-year bonds.

One often hears discussions about U.S. High Yield being tight especially now, but is it? The U.S. High Yield Index has changed significantly in structure, but those changes have often been overlooked. The composition of CCC’s in the index has fallen, the percentage of senior secured bonds has increased to 30%, the duration is shorter, and the composition of BB entities have increased, so of course the index looks tight compared to 5, 10 or 20 years ago.