Presidential Election Is the Only Cloud for Credit Investors

By Paul J. Davies

Investors piled back into corporate debt as hopes of an economic recovery grew. The only cloud on the horizon now, based on options markets, is the presidential election.

The rally in credit markets has been helped by companies repairing their balance sheets and ensuring they have plenty of cash. By some measures, the extra income demanded by investors to hold corporate bonds instead of government debt -- known as the spread -- has fallen to near record lows.

But in options markets, there is unusually high demand for hedges against a credit market selloff in November, when the election takes place, according to analysts. This can be seen in the cost of buying protection against big moves in U.S. investment-grade credit using options on the most liquid credit index, the CDX.

"Right now, the market pricing says there is specifically a significant amount of uncertainty around the election and then it drops after," said Viktor Hjort, global head of credit strategy at BNP Paribas.

That is unusual because hedging costs typically increase the further into the future you go, because of increased uncertainty. The link between hedging costs and time is known as the term structure.

"Normally, such a term structure points upwards, implying that there's steadily more uncertainty the further out in time you look," Mr. Hjort added.

Investors are worried about the risks of a contested election as well as the difference between the level of public stimulus with either a Republican or Democrat victory.

The cost of hedging against a big lurch upward in yields on corporate debt can be seen in expected future volatility. For October, it is about 61%, before jumping to 67% for November and then falling to under 65% for December. Normally, these numbers would rise steadily over time.

Expected volatility has dropped dramatically since March, when credit markets were hit by the onset of the Covid-19 crisis. The recovery has been driven by central banks' support and companies looking to strengthen their balance sheets to help withstand the effects of social distancing and lockdowns.

"I'm calling it a golden age for credit," said Greg Peters, head of multisector and strategy in the fixed-income division of U.S. fund manager PGIM. "There is passive conservatism among companies in terms of balance-sheet management: They are deleveraging and holding more cash."

In the most actively traded credit indexes, the spreads on corporate bonds have tumbled from their peaks in March. For example, on the CDX index of investment-grade credit default swaps, which investors can use to get insurance against companies going bust, spreads have dropped from more than 1.5 percentage points to less than 0.7 percentage point.

Remove the 10 companies with the highest spreads, which includes companies that have had their ratings downgraded, such as Ford Motor Co. and Boeing Co., and the rest of the index is trading at close to record lows at just over 0.3 percentage point, according to JPMorgan.

In Treasury markets, U.S. 10-year yields slipped slightly Thursday to 0.677%, from 0.686% at Wednesday's close.

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