Are credit investors nervous about recession risk?
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There's understandably been a lot of attention paid to U.S. stocks recently, but there's also something quite interesting happening in the U.S. bond market. Corporate bond spreads that reflect the additional yield on corporate bonds above government bond yields have risen dramatically in the past month.

So what should we make of that? Does it mean that bond investors are hunkering down for a recession? I'm Alison Nathan, and this is Goldman Sachs Exchanges. Today, I'm joined by Latvi Karawi, our Chief Credit Strategist and the Head of Credit, Mortgages, and Structured Products Research. Latvi, welcome back to the program. Thank you for having me. So Latvi, first catch us up. There's a lot going on. Give us some sense of what's been happening in the corporate bond markets in recent weeks.

Yeah. So there is this general perception among many people that corporate credit has sort of been resilient and it's outperformed its beta relationship to the equity market. That's actually just optical illusion. If you look at how much spread widening we've had since the peak of the market in mid-February, it's been exactly equivalent to what you should expect with an S&P that is down roughly eight to eight and a half percent. And so

I think what's creating a little bit of confusion is really that the starting level is so tight and optically it looks like investment grade spreads are still below 100 basis points, which is true. I mean, that is tight when you put it in historical context, but the change or the additional risk premium that has been building up since is very much consistent with the move that you've had in equity. And so I would say we're in the midst of a gradual rebuild of risk premium.

And our view is that that process has room to go. Right. Well, just to clarify, we started at a very high level of the S&P 500 too. So we're still at high levels relative to history and we are coming from very tight levels in credit that are now wider. So talk to us about what's driven this big increase in spreads.

Policy uncertainty. Basically, the gradual realization that we are in a macro environment with structurally higher volatility and certainly a lot higher volatility than many had anticipated going into the year. And so I would view that rebuild the premium as essentially a process in which spreads have to realign themselves with that new reality. We can talk about the impact of tariffs.

But at the end of the day, what they do, they essentially shift the trade-off between growth and inflation in a direction that is not that friendly for risk assets and credit in particular. And so until you recalibrate

things back into a friendlier trade-off between growth and inflation, I think you should continue to expect to rebuild the premium. The three other things I would add really, one, you're absolutely right. I mean, valuations do matter when uncertainty is elevated. It didn't matter last year when the economy was steadily growing, the Fed was sort of delivering the cuts.

Now we're in a different situation where you have to demand a high risk agreement in the face of a risk distribution that looks very different. And so the fact that we started the year with very severe valuation constraints clearly put portfolios in a position of vulnerability. And then the two other things I would say is that, look, there are

safer and competing alternatives to risk assets and credit. Cash still pay you 4%. Duration, look at where 10-year yields are, four and four and a quarter. If we have an accident in the cycle, duration can provide a very solid embedded hedge to multi-asset portfolios. And so what could reverse it? We'll see. Generally, an even bigger repricing of premium can actually reverse all of this because you attract new capital and people buy the dip. But our sense is that we're not there yet.

But just to be clear, fundamentals themselves are not showing signs or meaningful signs of deterioration. And this is just all about concerns that they might, given some of these growth concerns in particular and inflation concerns you just highlighted? Yeah. I mean, I would describe this as a repricing of risk premium as opposed to tangible signs of deteriorating fundamentals. But you're absolutely right. I guess the tension is between

spot data, which is looking pretty good. And then that's true whether you look at macro or like standard econ activity type of data, or also whether you look at corporate balance sheets

In general, I think things look pretty firm. The forward signal, however, is a totally different story. And I think the fact that that forward signal has turned more negative is enough in our view to justify a bit of repricing of premium. And so it is a repricing of risk premium as opposed to nervousness, at least at the moment, over the prospect of an abrupt deterioration in fundamentals.

Right. And because ultimately, the risk of recession does seem to have gone up fairly materially in the last several weeks. Incrementally. Off of very low levels, again. Right.

And so that's something I think we should be very clear about. We're not forecasting spreads going to recession levels. We are saying that we've had a couple of quarters now where spreads were stuck at the very low end of the historical range. They should gradually go back to levels that are closer to historical medians in order to reflect that new reality, which is

of elevated macro volatility and then incrementally higher recession risk off of a very low level too. And the market is far, just to be clear, from actually pricing a recession. I mean, how much further would spreads widen in a real recessionary scenario? The recession narrative, I would say, has come back in client conversation. That is unquestionable. If you look at levels, we're still far away from getting close to recession level. So just to give you a little bit of sense,

If you look at the IG bond index, it trades at a spread of roughly 95 basis points. Recession levels would probably imply levels that are closer to 200 basis points. And so you would have to double basically the amount of premium to get to those levels. And if you look outside of the US, the news seems to be better out of Europe. So is this just a US phenomenon? What are we seeing in Europe and

Does that make credit markets more attractive in Europe? Europe has performed very strongly. I mean, it's performed strongly on the equity side, but also on the credit side. A lot of that is obviously a reflection of better growth sentiment there. You will spend more on the fiscal side, so that is stimulative to growth, while the U.S., you know, we've essentially injected a meaningful dose of policy uncertainty into

And so markets took the opposite direction. Can that outperformance extend on a forward basis? I mean, I'll talk about credit.

When I look at European credit, I think it can continue to outperform in relative terms, but I think the scope for more tightening in absolute terms is quite limited. I mean, it would be very unusual actually to see those two markets diverge. History tells you that that actually rarely happens. But then more importantly, because Europe outperformed so well actually over the last two months,

European spreads are essentially back to the same valuation conundrum that dollar spreads were stuck into for most of 2024. And so you do have pretty binding, I would say, valuation constraints in the euro market. So to me, it's a relative play. Sure. I think growth sentiment is better. You're going to spend more. And so you have a tighter range of outcomes from a policy standpoint in Europe, but

But in absolute terms, I think the bulk of the outperformance is behind us. Right. And ultimately, it feels as though a lot of the good news is therefore priced in Europe. Absolutely. So when you take a step back, where does this really leave credit investors at this point? Where do you think credit spreads are heading?

So our view, again, is that you're set up for a gradual sort of reversion towards historical medians. I'll take the IG index as an example. Again, we're roughly at 95 basis points today. We think you'll peak at an average of 120 to 125 basis points. That is actually, you know, it seems like a big move from current levels. But if you take that number and put it in historical context,

you're sort of at the median of the last 25 to 30 years. And so it's a little bit of a 2018 type of playbook where the market is set to continue to digest this uncertainty. As a result of that, you will continue to build some risk. Now, that's a spread conversation.

The total return conversation is a very different one because if you're a total return investor, you have good support from the risk-free component or the treasury yield component. Yields are still high, at least relative to the history from 2010 to today, and I think it

it still very tough actually to derail total returns because one of the really interesting shifts that's been taking place the last couple of months is that the correlation between bonds and risk assets is actually back to where it used to be pre-2022. And so if spreads widen hypothetically to more than we think, to 150 basis points, because actually the odds of a recession are going up, you will get a solid embedded protection from the yield component

And so, your price return over at least a two to three month period is unlikely to dip into negative territory very much. And so, the bar is high, I think, when you think about total returns for bonds, the bar is really high for those total returns to turn deeply negative, which is a big shift relative to 2010, 2019, when actually the investment grade market was pretty much a spread product because the base yield component was very thin. You didn't have that cushion basically that would act as a line of defense.

when the cyclical outlook deteriorates. Right. And then if you think about the overall landscape of assets and products that you look at, are there pockets that are actually more resilient if we do see growth concerns grow and materialize? We're directionally negative. So naturally, that leaves us short beta a little bit. We do have strong conviction in owning agency mortgages relative to investment grade. And so that's a perfect example of a low beta

asset class that is a lot less sensitive to these fluctuations or these phases of desaturation and growth. We like it for a number of reasons. One, it's a bit more defensive. It's a lot actually more defensive than IG. And then number two, valuations are a lot more attractive than they are in IG. I mean, this is an asset class that has no credit risk.

And yet, it pays you a very generous success premium relative to IG. Of course, there are reasons why that's the case. We could talk about it, but it's a good example of an asset class that gives you good income

a bit of excess spread, and it has the ability to withstand potentially a period of slower growth. Away from that would be up in quality. We had two years where we kind of like carry over quality. We were comfortable owning BBBs versus BBBs. At some point, we were even comfortable owning triple C rated bonds, which are really at the low end of the quality spectrum and high yield. We switched that view a little bit. I think if you're directionally negative on the market, you kind of have to be up in quality too.

Talk to us just for one more minute, though, because your comment about mortgages was interesting. A lot of people, I feel like, think that housing and mortgages are quite cyclical and exposed to some of these risks, but you're saying they're not. Yes. These are agency mortgage-backed securities, and so they do benefit from an implicit guarantee from the U.S. government. And so there is really no guarantee.

credit risk embedded in them, and there's very little correlation with the performance of the housing market. And so what you're really taking a view on is the risk of prepayments of these mortgages, nothing more. But as far as credit risk goes, unless you're nervous over the credit worthiness of the US government, but there's- That's another conversation. Exactly. There's virtually no credit risk basically in there. Understood. So-

If the Trump administration walks back, some of the news and announcements that have really increased the growth and recession fears on tariffs,

for example, and equities bounce, will credit also reverse some of the recent moves? Yeah. I think if you recalibrate sort of the policy agenda away from measures that are negative for growth back into some of the actions that are more pro-growth, absolutely. I mean, the one thing you need to hope for is that between now and then, there isn't enough damage that's

that's been done to the economy so that the market is comfortable sort of going back and mean reverting. But absolutely, I mean, in fact, actually the first three months, almost three months of the year,

felt to me as if we kind of skipped 2017 a little bit and we went straight into 2018 by delivering all the tariffs, et cetera. But yeah, I mean, there's a lot of sort of pro-growth measures in the current agenda that could reverse things. I mean, deregulation is one of them, obviously tax cuts, all that is stimulative to growth. But the timeline is sort of key. I mean, you want to get there at a time when the economy is actually still holding up pretty well.

So assuming that we don't get this better news or the concerns at least continue for a while, you know, are you concerned that we are going to see more defaults and more actual deterioration in fundamentals that could then again inflict that damage you just mentioned?

Yeah. So again, it really depends on what the baseline view is. Ours is that we're poised for some deceleration in growth and a temporary boost to inflation. And so I would expect that to fuel some deterioration in fundamentals, but not a lot. And so the widening in spreads that we envision is really a repricing of risk premium, i.e. investors demanding a higher premium against that risk.

as opposed to something that would be driven by rising defaults or negative ratings migrations because balance sheets are coming under pressure. Now, of course, if you look at the risk that we get a more severe deterioration in the cyclical outlook, that would certainly bring defaults back into the conversation. Always an interesting conversation, Latvi. Thanks so much. Thank you. This episode of Exchanges was recorded on Friday, March 14th. I'm Alison Nathan. Thanks for listening.

Thank you.

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