What has driven yields higher – rates or credit?

The rapid move higher in bond yields so far this year has caused losses across virtually every corner of the fixed income market, leaving investors with nowhere to hide.

For credit assets, the effect has been two-pronged; yields have risen both because of widening credit spreads (which reflect the risk premium investors demand for holding credit over risk-free government bonds) and because of the risk-free rate itself, which has shifted sharply upwards as a result of inflation and the subsequent anticipation of interest rate hikes.

If we look at the magnitude and contribution of both these elements to the change in yields across a number of sectors and geographies, we can see why the recent period of volatility has been so painful for investors.

Clearly the higher quality assets have been hurt more by the rates move than by credit spread widening, while the reverse is true of the higher yielding, lower rated assets. As we noted earlier this month, what is unusual about the table above is that the correlations between rates and credit have been positive, when normally they are negative. Credit spreads are higher and rates yields are higher. This is often a common feature when rates risk becomes the dominant concern in the market, which has been the case for most of the year so far. Markets do become quite uncomfortable when this correlation breakdown happens, though typically it does not tend to last for long. However, this recent breakdown does seem to have been relentlessly long and painful, causing investors to hoard cash in a magnitude normally associated with a major crisis.

In recent days, this correlation breakdown has been showing signs of normalising, which should give investors some comfort, as should the large amounts of liquidity that have been built up. For example, the Fed’s reverse repo facility recently broke through the $2 trillion barrier for the first time, and the latest BofA fund manager survey showed cash balances at levels not seen since the global financial crisis. 

So while the first five months of the year have been quite brutal for investors, there are some signs that the negative technicals are beginning to show signs of improvement, particularly in fixed income. This is leading to comments such as those from Jamie Dimon at JP Morgan’s investor day on Monday – “credit looks really good, we’ve never seen it this good” – and should help in restoring some investor faith to this important part of the bond market.