Is Credit at a turning point?

Some market downturns are triggered by exogenous events that were unforeseen, often called Black Swans. The correction of April 3, 2025, can't be placed in that category. President Trump's "liberation day", when the US announced a 10% universal tariff on all countries and a range of "reciprocal" tariffs on a range of countries (ranging from 10%-50%), was widely telegraphed, not least by the President himself.

So why did risk assets - including credit - go into reverse? The breadth and depth of the tariffs went beyond most expectations. The US will now have an effective tariff rate of 22.4% (Yale Budget Lab), higher than the Smoot-Hawley level in the 1930s and not seen since the first decade of the 20th century.

A new era of protectionism appears to be upon us. Is this the catalyst for a decisive shift in the credit cycle? The movement in CDS indices indicates a material change in sentiment. S&P' DJI's iTraxx and CDX indices - tradable products that are highly liquid and excellent barometers of credit risk - widened significantly. The CDX IG index moved nearly 5bps to 65.5bps, its widest level since November 2023. While this daily move is not in the same bracket seen during the extreme volatility of 2020, it is still in the top 3% (excluding index roll dates) since the beginning of 2020.

The equivalent index in Europe, the iTraxx Main, widened by a similar amount to trade at 68.5bps. This needs to be placed in recent context. During the post US election euphoria, when US exceptionalism was at its height, the CDX IG was trading in the 47-50bps range, a full 10bps tighter than the iTraxx Main. They converged as risk aversion rose in North America with the initial tariff announcements and the EU - particularly Germany - promised a Keynesian fiscal injection.

Investment grade credit markets went into 2025 with strong technical tailwinds. Supply of paper - though robust - was outstripped by demand due to an abundance of capital. All-in yields were relatively high and attractive to investors. Spreads were historically tight in the bond market and also in the synthetic market; the long run median of the CDX IG is 70bps.

Despite the pervading uncertainty - likely to be the word of the year - the index is still below this average level. Bulls in IG credit will point to the strong fundamentals (leverage and interest coverage), balance sheet discipline and the willingness and capability of BBB credits to maintain their IG ratings. But the risks are clear: EBITDA could suffer if a trade war causes a marked reduction in growth and the technical bid fades in strength.

These risks are perhaps even more pertinent to high-yield. The CDX HY index is now trading at 405bps, 24bps wider on the day and well over 100bps north of its level in December. This is a significant move. At the beginning of the year it was trading at the same level as the iTraxx Crossover - now it is 58bps wider. Credit quality is poorer in North American HY compared to Europe and the recent moves reflect investors reducing risk at the weaker end of the credit spectrum.

The consensus view going into 2025 was that spreads would continue to tighten, supported by strong demand, robust fundamentals and a soft landing in the economy. That view, while understandable and still possible, now looks less feasible . Much will depend on the extent and duration of the tariff programme - will elements get reversed and how will the rest of the world respond? The policy decisions of the Fed and other central banks will also be crucial.

But this new regime will also present opportunities to credit investors. Dispersion was already on the rise and the impact of tariffs will mean some sectors and individual names will lose out more than others. National governments will react in different ways. Credit selection will be paramount as well as prudent risk management. Instruments such as the CDS indices and CDS index options (the best hedge of credit volatility) may gain in popularity (the chart above shows trading volumes rising in CDX ahead of the tariff announcement).  If complacency was evident in credit last year there is surely no room for that in 2025.