Credit spreads have been widening for while on the back of corporate re-leveraging. In the US, the abundance of cheap money has incentivised corporates to borrow in order to buy other companies – the number of M&A deals has now exceeded 2007 levels (see Cross-Asset Flash, 16 March 2016).
Buybacks have also increased, enabling companies to improve their earnings per share (EPS) despite weakening revenue. In Europe, corporates have further increased their leverage by distributing larger dividends in order to support equity prices that have been hampered by years of weakened economy. Credit markets have reacted to weaker fundamentals Since 2014, credit spreads have steadily widened as it has become clear that corporates are using cheap funding to favour equity holders.
Central banks have done their best to reduce the overall costs by pushing rates down and curves flatter. However, Chart 1 shows that high grade credit spreads have been between 50-75bp wider than the tight levels seen in 2014 in Europe, and up to 100bp wider in the US (even wider for lower credit quality names).
Credit spreads only started to re-tighten in March, after the more dovish Fed and ECB announcement of more unconventional measures (including bond buying). This shift in central bank stance has also helped leveraged loan markets recover from a tough 2015, after years of steady returns, and this supportive move for credit should continue