As we have seen, the COVID-19 pandemic has caused a tremendous global toll of death and suffering while also driving financial markets to steep losses. Aside from the well-covered losses in global equity markets, another key impact has been felt on the credit markets. The key determinant of credit market loss has come from the tremendous widening in credit spreads that began in late February and peaked to a recent high on March 23. When credit spread widen, all else being equal, bond values go down and unrealized losses emerge. Credit spreads widen in a crisis as a mechanism to compensate buyers of debt for the increased risk of default.
On March 23 the high yield bond index hit its recent wide credit spread of 1,037 basis points (bp) and the corporate investment grade bond index hit 401 bps from their recent stable levels earlier in the year of about 400 basis points and 100 basis points, respectively (see chart below). The chart clearly shows that a widening of spreads correlates highly with recessions. Due to some dramatic actions from the Fed and huge fiscal stimulus taken (see my previous post here for more info: https://www.dattilioash.com/our-blog/2020/4/9/new-ball-game), credit spreads for high yield and investment grade corporate bonds have narrowed from those levels to 777 bps and 221 bps, respectively, on May 14 - so far, before spreads widen to the dramatic level seen in the Great Recession of 2008/2009.
These widened credit spreads translate directly into total return losses. On a year-to-date basis, high yield bonds (HYG) have returned -8.83% while investment grade corporate bonds (LQD) have recovered a bit to show a small gain of +1.50%. It is worth noting that both high yield bonds and investment grade corporate bonds came off a great year in 2019 with returns of +14.09% and +17.37%, respectively, so the retracement so far in 2020 simply serves to move these markets closer to a long term return profile.
Most thought leaders seem to agree that the capital markets will follow the path led by the coronavirus; good results will lead capital markets higher and vice versa. However, there is no way to know how the future will emerge. It is reasonable to expect credit spreads to come back in to historical norms when the economy starts to see some signs leading to normalcy. This will lead the bond market to positive returns from here, all else being equal. In the meantime, it is prudent to be a long term investor and stay well-diversified to capture the recovery in capital markets without realizing losses.