Tight high-yield spreads flash caution signal

Instead of chasing Alpha, prepare for the turn

Credit spreads continued to grind tighter in March with both high-yield and investment-grade spreads approaching the lowest risk premiums since 2007. Risk assets have shaken off a dramatic repricing of rate cuts from the U.S. Federal Reserve in 2024. In the past quarter, market pricing has shifted from six rate cuts in 2024 to only two or three.

March was an active month for new issues in Canada and the U.S. high yield markets. While strong upward momentum in asset prices continued in March, there is relatively limited room for spreads to move tighter from here if history is any guide. Aside from high-level risk premiums, there are plenty of examples of individual situations where speculation is driving asset prices.

The performance of Trump Media & Technology Group Corp. (NSD: DJT) bears a lot of resemblance to the meme stock bubble of early 2021. While DJT might be the most dislocated stock in the market in terms of price relative to fundamental value, there are others like Super Micro Computer Inc. where the market’s appetite for AI-themed trades has caused price movement that greatly exceeds fundamental developments in our view. We view Bitcoin, which hit an all-time high in March, as another data point on generic market speculation and financial conditions.

On March 21, the ICE BofA US High Yield Index hit 305 basis point (bp) Govt OAS, the tightest spread in over two years, and just 4bp away from the tightest spread since 2007. Year to date, there has been a clear negative correlation between yields and spreads as both high-yield and investment-grade markets have been supported by “all-in” yield buyers when government bond yields moved higher.

With the past year seeing the highest sustained government bond yields since before the Global Financial Crisis of 2008, it is entirely possible that spreads break through 300bp OAS in high yield for the first time since 2007.

Major market bottoms in spreads have consistently seen significant spread-widening events within the following six months for the past decade. We thought it was worthwhile to revisit the 2006-07 market experience to see if the same rule held for even tighter spreads.

Following spreads bottoming at 241bp on June 1, 2007, spreads hit 400bp within two months and peaked at nearly 600bp within six months. Even in a very robust risk-taking environment, the market only spent about six months in total below 300bp OAS. While there will always be differences between cycles, we believe it’s very clear that it is not a market environment to be chasing market beta.

With spreads approaching cyclical lows, the skew to asset prices clearly favors a defensive posture in our view. While positive momentum can continue from here, eventually there will be a shift and we believe it is appropriate to be positioned for that turn rather than try and squeeze the last bit of momentum from the market.

Justin Jacobsen, CFA, is the Portfolio Manager of the Pender Alternative Absolute Return Fund. PenderFund Capital Management. Excerpted from the Pender Alternative Absolute Return Fund Manager’s Commentary, March 2024. Used with permission.

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