LDI chart update: Where next for credit spreads?

As investment grade credit spreads have remained relatively tight for some time and expected potential excess returns appear low, some investors have been hesitant to allocate more to credit.

 Where are we now?

As of 28 June 2024, the yield on the iBoxx non-Gilt index traded at c.1.09% above government bonds, representing the potential annualised excess return for holding credit to maturity versus the equivalent government bond. Historically, spreads are relatively tight and have been tight for some time – they are currently around the 12^th percentile and have been below the 25^th percentile for 156 days.

Credit spreads have been well supported by yield-sensitive investors looking to lock in potentially attractive all-in yields in a relatively benign default environment. Spreads have largely shrugged off recent geopolitical uncertainty with only idiosyncratic stories playing out in different markets.

Where next for spreads?

Credit spreads have historically tended to be a mean reverting asset and so one can guess that they may not remain tight forever. This leads to two potential routes in our view.

Firstly, spreads could grind on at tight levels for some time. Looking again at the historical range, the time spreads have been below the 25^th percentile is roughly average and there have historically been instances when they remained tight for longer periods. Investors sitting on the sidelines waiting for spreads to widen could miss out on potential credit carry (the accrual of credit spread due to passage of time).

Alternatively, spreads could potentially widen from here to make for more attractive entry points. However, it’s worth noting that the time to capture this opportunity may be short. If we look at spreads above the 75^th percentile as a potentially attractive entry point, this opportunity has on average only been around for 174 days.

Furthermore, this average is skewed due to periods of financial stress, including the 2008/09 financial crisis and 2011/12 European debt crisis. Looking at the median period, this falls to 67 days. Therefore, if investors are waiting for spreads to widen, then if it were to occur, they must have the sufficient governance in place to capture the potential opportunity quickly.

If you’ve enjoyed this blog post, please click here to discover more of our content that’s specifically tailored for DB schemes.

You can also sign up here to receive the latest content most relevant for you via email.