J.P. Morgan on Watch to Watch in Credit Markets in 2021
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Credit spreads were tight at both the start and end of 2020—and a group of J.P. Morgan analysts see them getting even tighter in 2021. But the moves aren’t likely to be anywhere near as dramatic as they were in the past year.
U.S. investment-grade corporate bonds started 2020 yielding 127 basis points more than Treasuries with similar maturities. (One basis point is one-hundredth of a percentage point.) That spread widened—meaning investors saw these types of bonds as riskier—to 387 basis points during the market’s turmoil in February and March. The spread, however, has since returned to 127 basis points, exactly where it began the year. J.P. Morgan credit analysts, including global head of credit research Stephen Dulake, expect the investment-grade spread to tighten by another 2 basis points by the end of 2021.
U.S. high-yield bonds were much more volatile in 2020: They entered the year with a spread of 424 basis points above Treasuries, with the spread hitting a peak of 1,139 basis points in March. By the end of December, the spread was back down to 447 basis points—and J.P. Morgan analysts see it dropping to 425 basis points sometime in 2021.
What’s behind the tightening spreads? Thank an improving economic and earnings environment and continued yield-suppressing policy from the Federal Reserve. Although not his base case forecast, Dulake is watching to see if those conditions lead to a potential melt-up in credit markets in 2021.
At this point, the J.P. Morgan analysts don’t see most investors getting too creative for their own good in the low-yield, tight-spread environment. Many learned their lessons in the global financial crisis when certain complex credit strategies blew up.
“While there’s a general perception that spreads are tight, we don’t yet get the sense that credit investors are over their skis and either getting overly-levered or overly-complex as they did back in the mid-2000s,” the analysts wrote in a Thursday report. “Rather, the focus appears to remain on monetizing illiquidity premiums, infrastructure, private credit, and direct lending, than it does monetizing complexity premiums via structured products.”
Dulake and the other analysts expect to see companies reducing their cash balances in 2021, in favor of increased shareholder returns and debt reduction. During the Covid-19 pandemic, many firms pulled back on spending, drew down their credit lines, and issued new debt. Some needed the cash to get through business interruptions, while others thought it couldn’t hurt to have a bit more of an insurance policy.
As the pandemic recedes, the economy recovers, and operations generate more cash, that extra money on corporate balance sheets can be put to work. Besides companies repaying some of their borrowings, the J.P. Morgan analysts expect to see more share buybacks, dividend increases, and mergers and acquisitions in 2021.
Finally, they’re also focused on the pair of Georgia special elections on Jan. 5 that will determine who controls the U.S. Senate for the next two years. If Democratic candidates win both seats, the victories will give their party control of the presidency and both chambers of Congress. That could mean more fiscal stimulus in the near term, the analysts predict—though there might be higher taxes down the road to pay for the extra spending.
“The initial reaction would be positive, as stimulus would likely come first (though one potential fly in the ointment could be a snap higher in underlying bond yields and interest rate volatility),” the analysts wrote. “Looking further forward, if higher capital gains taxes prove to be one result of a Democratic Administration and Democrat-controlled Congress, this is much more negative for equity than credit investors.”
If more spending and borrowing lifts Treasury yields, that could push up yields on corporate bonds, too.
Write to Nicholas Jasinski at [email protected]
