High yield (HY) bond spreads have widened sharply, sparking concern that the sell-off foreshadows an economic slowdown that could hurt equity markets. US cash HY spreads are around 60 basis points (bps) and European HY 50bps wider since their 24 October lows.
But the correction stands out more because of current tight spreads and low bond volatility. We do not consider it a reason for equity investors to panic:
- The October low in European HY spreads of 233 bps was the tightest point in the post-crisis period. Even after this, correction spreads are close to 100bps tighter on the year, while US spreads are about 25bps tighter.
- Credit fundamentals remain sound. The 12-month default rate is expected to stay below 2% in both the US and Europe next year, about half the 20-year average. Recent HY weakness has been centered on specific names (particularly in telecommunications) that have delivered weak earnings.
- Strong HY performance has been driven by solid GDP growth, low inflation, low/negative interest rates and quantitative easing in Europe/Japan. These factors remain in place and are unlikely to change in the coming months.
With credit and economic fundamentals supportive we believe wider HY spreads reflect an overstretched market vulnerable to a correction rather than a precursor to a recession. For valuation reasons we remain underweight European HY, where 18% of the bond universe offers a total yield of less than 1%. Further sharp spread widening would likely affect equities, but our base case is that spreads will stabilize and widen more gradually, which should not unsettle global stocks.
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