Credit Risk Premiums to Surge to Early Pandemic Level If Fed Missteps on Policy

(Bloomberg) — Risk premiums in the US investment-grade market could surge to 200 basis points if the Federal Reserve pauses rates too soon, according to bond investors.

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“Once the Fed pauses, the market is really going to latch onto the idea that the next move is an easing,” said David Del Vecchio co-head of US investment grade corporate bonds for PGIM Fixed Income speaking at Bloomberg Intelligence’s 2023 Global Credit Outlook Thursday. “If the next move is a tightening, that’s a disaster, and that’s where we get to those 200-type spreads on credit. That’s probably the biggest risk.”

Spreads have only breached 200 basis points a handful of times over the past two decades. They surged past 600 during the global financial crisis and peaked at about 375 during the early days of the pandemic.

Risk premiums across credit remained relatively tight this year despite a looming economic downturn. The average spread for high-grade bonds jumped to 165 basis points in October but has since dropped to 130, according to Bloomberg-compiled data. That is much lower than levels typically reached during a recession, but a policy error by the Federal Reserve could very well push them back to that level.

The key issue next year will be how fast inflation comes down closer to the Fed’s 2% target, the panelists said. The risk to corporate credit is if the Fed pauses rate hikes too early and then is forced to raise them again because inflation remains too high.

“That’s the tail risk, the real risk,” said Lisa Coleman global head of credit at JPMorgan Asset Management. “If the Fed has to respond much more aggressively, then you start getting into periods where you can have financial mishaps and some of the cracks become more apparent.”

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That is not the base case for the panelists though. Del Vecchio said that a soft landing is still possible next year and there is a chance that investors will look past the recession, keeping spreads narrow. Corporate fundamentals are also strong, he said, and he doesn’t expect a wave of downgrades across high-grade bonds next year.

He likes short-dated corporates, BBB rated bonds and issuance tied to merger and acquisitions. Coleman sees opportunities in Europe where the market has priced in more recession risk than in the US.

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