Credit Spreads - What and Why They Matter

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1. Credit Spreads - What and Why They Matter

Good morning and happy Tuesday - let's get smarter

Credit Spreads - What and Why They Matter

One of the biggest signals of a changing economic environment sits in the credit market

Specifically, credit spreads

The credit market is just the market where companies and government's issue debt to investors

Most people are very familiar with "stonks" / equities

But, a lot of prominent investment firms make their money buy purchasing debt from a bank that doesn't want that liability on their books

For example, some of the banks that loaned money to Elon Musk for the acquisition of Twitter we're willing to sell their loans at 60% of their value

Why would they do that?

They had real concerns over Twitter's ability to generate enough cash flows to repay the debt

So rather than risk getting nothing, they can sell their debt to someone at a discount that is willing to collect the high interest rates to compensate for the chance that Twitter cannot repay the amount owed

Investing in a debt/fixed income instrument has a maximum amount of upside

You will be paid the principal payments from the company as they repay their debt and the interest

As a holder of equity, you have infinite upside

That's often why debt investors and equity investors typically have very different opinions on the strategic decisions of the company

They have different return profiles, different risks, etc

Owning fixed interest rate debt, you are only going to get that interest rate + the loan repayments amount. Never more.

Credit spreads are the difference in yield between two fixed income securities with different credit ratings, such as a government bond and a corporate bond. Specifically, it's the difference in yield between a bond with a lower credit rating and a bond with a higher credit rating

Here is the credit rating score chart. The more riskier the debt, the lower the rating, but the higher the interest rate / return an investor can get

Risk and return move together

When a bond is issued, it is assigned a credit rating by a credit rating agency, which reflects the issuer's creditworthiness and ability to repay the bond's principal and interest payments. A higher credit rating generally indicates a lower risk of default, while a lower credit rating indicates a higher risk of default.

Investors demand a higher yield on bonds with lower credit ratings to compensate for the additional risk of default. As a result, the spread between the yield on a bond with a lower credit rating and a bond with a higher credit rating will be wider. The size of the credit spread reflects the market's perception of the issuer's creditworthiness and the risk of default.

As credit spreads start to widen, this is a signal that whoever is taking on/buying this debt/fixed income instrument sees more risk in potentially collecting their principal payment, so they require a higher interest rate to compensate for the risk

As you can see in the graph below, credit spreads widening typically are a pretty good sign of recessionary economic environments

Well if credit typically front runs a large change in the equities market, what typically front runs the credit markets?

Unemployment continuing claims

Unemployment continuing claims refer to the number of people who have filed for unemployment benefits and are still receiving them in subsequent weeks. It is an indicator of the ongoing level of unemployment in an economy

When a person is laid off or loses their job, they may file for unemployment benefits from the government to help them financially until they find new employment

Continuing claims represent the number of people who continue to receive unemployment benefits in the weeks following their initial application

The number of continuing claims can indicate the level of labor market distress and is closely monitored by economists and policymakers. High levels of continuing claims suggest that there are still many people out of work and struggling to find employment. Conversely, low levels of continuing claims suggest a stronger labor market, with fewer people relying on government assistance

Unemployment continuing claims can impact credit spreads in several ways

First, high levels of continuing claims can indicate a weaker economy and a higher risk of default among issuers of lower-rated bonds. This can lead investors to demand higher yields on these bonds to compensate for the increased risk, resulting in wider credit spreads.

Second, continuing claims can also impact consumer spending, which can in turn affect corporate earnings and creditworthiness

If there are many people out of work and receiving unemployment benefits, they may have less disposable income to spend, which can hurt the profitability of companies and their ability to service their debt obligations. This can lead to wider credit spreads for the affected issuers.

Finally, continuing claims can also influence the monetary policy decisions of central banks. If there are high levels of unemployment, central banks may choose to keep interest rates low to stimulate economic growth and job creation.

However, this can lead to higher inflation expectations, which can increase borrowing costs for issuers of lower-rated bonds and widen credit spreads

Before chasing stocks as they have a big up day and you have FOMO, check under the hood of the economy and make sure you see what's really happening

It's not as warm and fuzzy as people make it seem

- Dev

DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.