Tightening Credit Spreads in a Rising Rate Environment

Jen Ripper

By Jen Ripper | March 22, 2018

Over the past year, credit spreads across the fixed income market have grinded tighter. The commercial mortgage-backed securities (CMBS) market has experienced spread tightening up and down the capital stack. This week’s chart highlights the spread compression of 10-year AAA CMBS bonds relative to its yield. While risk premiums are declining, the recent rise of Treasury yields have provided relief to yield-hungry investors.

Ten-year treasury yields are fast approaching 3%, a level not seen since 2013. The Federal Reserve hiked interest rates once in 2016, three times in 2017, once so far in 2018 and has signaled two more hikes this year. While rising interest rates can negatively affect total returns in the short term, higher rates give investors the ability to add investments with higher yields that will result in greater returns over a longer time horizon.

Spreads across the risk spectrum in CMBS remain near 12-month lows. Tightening spreads have been supported by favorable demand, steady fundamentals and investors with cash to deploy. I remain cautious as we head into the later innings of this cycle, given forecasted decelerating growth and a flat credit curve. I believe higher rated investments are less volatile and will outperform in a spread-widening event. The incremental yield pickup is narrowing for lower rated securities. As all-in yields are rising, I feel there is no need to stretch for credit at this time, as spread compression may be limited.

 

Key Takeaway

I remain up in quality and shorter in duration with a flatter credit curve as a hedge against rising interest rates and decelerating fundamentals in commercial real estate. Moving into the later stages of the current real estate cycle, I remain cautious going down in credit given the current risk-reward opportunity.

 



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The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.

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This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.  This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.

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High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.

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