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The Waiting is the Hardest Part

Now looks like a good time for patience – especially with corporate bonds.

Despite the volatility of the last 12-18 months, credit spreads are still lower than historical levels. What’s credit spread? It’s roughly the difference between the yield-to-maturity for a corporate bond (or group of corporate bonds) and the yield-to-maturity for a Treasury bond (or group of Treasury bonds) with similar maturity.

The black line on the chart below shows the history of the credit spread for low rated corporate borrowers (i.e., those below investment grade). You can see that past economic stress (tech bust 2000-2002; financial crisis 2008-2009; COVID-19 2020) led to high credit spreads – far higher than the 5.1% observed at the end of 2022. The blue line shows that default rates are also below average1.

In addition, the corporate credit market is very different today than it was in past cycles. The market for secured loans to the low rated corporate borrowers (referred to as the “leveraged loan” market) is almost entirely (88%) made up of loans with weak covenants relative to historical standards (referred to as “covenant lite” or “Cov-lite” loans)2 as you can see from the nearby chart. I worked in the leverage loan market 2003-2007 and we were concerned then about the apparent surge in cov-lite loans in 2006-07. Little did we know.

When you put low credit spreads and weak covenants together you realize we are getting paid less (in the form of lower spreads) right now to accept more risk. Not a great combination.

This analysis highlights (in part) why we don’t try to trade around recessions (which feels tempting today) or other potential risk events. Instead, we pay managers like FPA to accept risk when it’s likely to be well rewarded and shun risk when it’s not. FPA Crescent Fund held 25% in cash as of 12/31/2022 – so we know that when financial market stress shows up again, and credit spreads move higher, FPA has the dry powder to take advantage of more attractive reward/risk scenarios.

With dry powder in hand, market anxiety becomes something to be embraced, not something to fear. Just gotta be patient. With thanks to Tom Petty, the waiting is the hardest part.


2. Ibid


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