UBS believes the credit market has not yet fully priced in growth shock risk and is waiting for wider spreads before buying credit

Overview

This is a UBS global strategy report focused on whether the credit market has already priced in a negative growth shock under the scenario of a U.S.-Iran conflict and oil price shock, and at what spread levels investors should buy credit. The report argues that the market has recently repriced the probability of conflict de-escalation, but the path to resolution remains uncertain; current credit spreads still look calm, with signs of compression and complacency especially in European investment-grade credit. Therefore, UBS does not advocate aggressively going long credit now, but instead waits for more attractive spread entry points and improves portfolio risk-reward through relative value and duration trades.

Core views

The core view of the report is that the credit market has not yet fully priced in a negative growth shock, and current risk-reward is skewed to the downside; only when US IG/HY spreads reach 115/415bp and EU IG/HY reaches 130/420bp does expected risk-reward become asymmetrically favorable. At the portfolio level, UBS prefers to maintain neutral global credit risk, reduce exposure to European credit compression, close Long EU A vs EU AA and EU IG Financials vs EU IG Corporate trades, and instead initiate Short EU BBB vs EU A and Long 10Y Bund vs EU IG.

Analysis framework

The report uses a combination of scenario analysis, spread valuation percentiles, historical growth shock comparisons, and portfolio simulated returns. The scenario section sets out three paths around the duration of the oil supply shock: a 5-week disruption, a 2-month disruption, and an extended disruption, and estimates spread levels for US IG, US HY, EU IG, and EU HY at the end of Q2 and in subsequent quarters. The valuation section compares current spreads with the past 5-year average and 0.5 to 0.75 standard deviation thresholds, and examines spread changes 3 months, 6 months, and 12 months after those thresholds were breached historically.

Methodology notes

• Scenario AnalysisOil Price Shock and Growth Shock Scenario

  Projecting credit spread paths under different conflict durations

  The report divides conflict disruption into 5-week, 2-month, and extended disruption scenarios, and based on these predicts spread changes in US IG/HY and EU IG/HY by the end of Q2 and in subsequent quarters.

• Valuation FrameworkSpread Standard Deviation Thresholds

  Using the past 5-year average and 0.5 to 0.75 standard deviations to judge whether spreads are wide enough

  The report believes that the entry levels of 115/415bp and 130/420bp correspond to about 0.5 to 0.75 standard deviations above the past 5-year average; historically, after these levels were breached, spreads usually began to tighten over 3-month, 6-month, or 12-month horizons.

• Portfolio ConstructionRelative Value and Duration Hedge

  Using tiered credit and rates relative value trades when directional credit risk is uncertain

  The report expresses credit tiering widening risk through Short EU BBB vs EU A, and relative return opportunities under slower growth or declining rates through Long 10Y Bund vs EU IG.

Asset mapping & comparison

Structured mapping from thesis to named assets (strengths, weaknesses, peers, risks).

• US IG

  Wait for wider spreads before buying the dip

  Strengths

  Fund flows show investors are shifting toward higher quality, with investment grade better supported than high yield.

  Weaknesses

  At around 89bp currently, spreads still do not fully reflect a negative growth shock and compensation is insufficient.

  Comparison

  The report suggests about 115bp as a more attractive entry level.

  Risks

  If the conflict is prolonged or the growth shock deepens, spreads may widen further.

• US HY

  Wait for wider spreads before buying the dip

  Strengths

  If spreads reach around 415bp, expected excess returns would be better able to withstand tail-scenario widening.

  Weaknesses

  High yield is more sensitive to slower growth and deteriorating risk appetite.

  Comparison

  At about 317bp currently, it is still around 100bp away from the recommended entry level.

  Risks

  Oil price shocks, recession concerns, and deteriorating credit fundamentals could lead to larger drawdowns.

• EU IG

  Currently cautious, and hedged via a relative trade with 10Y Bund

  Strengths

  If growth concerns drive rates lower, duration assets may benefit relative to credit.

  Weaknesses

  European IG spreads are viewed as compressed and complacent; at around 97bp currently they remain below the suggested buy level of 130bp.

  Comparison

  The report recommends Long 10Y Bund vs EU IG, rather than directly increasing directional long EU IG exposure.

  Risks

  If credit continues to compress and rates do not decline, returns on the relative trade may be limited.

• EU HY

  Wait for higher risk compensation

  Strengths

  Buying around 420bp could improve risk-reward.

  Weaknesses

  High yield is sensitive to growth shocks and shifts in risk appetite, and the current 332bp is still insufficient to compensate for tail risk.

  Comparison

  Under the extended disruption scenario, EU HY could reach 450bp by end-Q2 and may widen further in subsequent quarters.

  Risks

  Deteriorating liquidity, repricing of default risk, and downward revisions to European growth expectations.

• EU BBB vs EU A

  Short EU BBB vs EU A to express tiering widening

  Strengths

  In historical credit sell-offs, the BBB-A differential widened by about 85bp on average, versus only about 5bp since late January this year, giving the trade asymmetrical upside.

  Weaknesses

  If the growth shock does not materialize and credit continues to compress, the trade may be hurt by carry and spread compression.

  Comparison

  Switching from the previous Long EU A vs EU AA compression trade to a decompression trade of Short EU BBB vs EU A.

  Risks

  Short-term risk relief or yield chasing could continue to compress the BBB-A spread.

• 10Y Bund vs EU IG

  Long 10Y Bund and relatively short EU IG

  Strengths

  Scenario simulations show returns of about 0.85% under a 2-month disruption and 1.50% under an extended disruption, while being roughly flat under a 5-week disruption.

  Weaknesses

  The trade depends on rates improving relative to credit; if rates continue to rise, it may come under pressure.

  Comparison

  Compared with simply going long credit, this trade is more defensive and can benefit from slower growth or declining rates.

  Risks

  Renewed inflation concerns, a more hawkish central bank outlook, or further rises in European rates.

Key data

• Current US IG/HY Spreads89/317bpThe report states that current U.S. investment-grade and high-yield credit spreads are about 89bp and 317bp, respectively.
• Current EU IG/HY Spreads97/332bpThe report states that current European investment-grade and high-yield credit spreads are about 97bp and 332bp, respectively.
• Credit Buy-the-Dip Trigger LevelsUS IG/HY 115/415bp；EU IG/HY 130/420bpUBS believes risk-reward becomes asymmetrically favorable around these levels.
• End-Q2 Forecast Under 2-Month Disruption ScenarioUS IG/HY 105/400bp；EU IG/HY 120/415bpUnder this scenario, spreads widen further from current levels, but it is not the most extreme tail scenario.
• End-Q2 Forecast Under Extended Disruption ScenarioUS IG/HY 120/450bp；EU IG/HY 135/450bpThe charts show that credit spreads widen significantly under the extended disruption scenario and may continue widening in subsequent quarters.
• U.S. Credit Fund FlowsIG inflows about $13bn；HY outflows about $6bn；LL outflows about $2bnFund flows show that investors have a clear tendency to move up in credit quality.
• Historical BBB-A Widening ComparisonAbout 85bp on average in historical credit sell-offs；about 5bp since late January this yearUBS believes the widening of European BBB relative to A is still insufficient, and Short EU BBB vs EU A has hedging value.
• Simulated Return for Long 10Y Bund vs EU IGAbout 0.85% under 2-month disruption；about 1.50% under extended disruption；roughly flat under 5-week disruptionThe report believes this trade exhibits favorable return asymmetry under oil price shock scenarios.

Impact & implications

For portfolios, the report suggests that this is not the right time to expand directional long credit exposure while credit spreads remain tight; instead, investors should preserve cash for future credit buying and wait for higher compensation levels. European credit in particular warrants caution over a reversal of compression trades, and lower-rated investment grade may widen relative to higher-rated investment grade as growth concerns intensify. On the rates side, the 10Y Bund may outperform credit on a relative basis if growth expectations weaken or if short-term risk relief drives rates lower.

Risks

• A renewed escalation or prolongation of the U.S.-Iran conflict could trigger an oil price shock and wider credit spreads.
• A growth shock stronger than the base case, especially an extended disruption or a tail scenario in which traffic through the Strait of Hormuz is blocked for a prolonged period.
• The credit market may currently be underestimating the probability of a negative growth shock; if risk is repriced, both IG and HY could decline.
• Market risk, credit risk, interest rate risk, and foreign exchange risk could cause multi-asset portfolio returns to fall short of expectations.
• During periods of high volatility, thinning liquidity, and economic dislocation, valuations may be adversely affected.

What to watch

• Whether the U.S.-Iran conflict cools quickly or re-escalates.
• The duration of the oil supply shock and whether traffic through the Strait of Hormuz normalizes.
• Whether US IG/HY approaches 115/415bp and EU IG/HY approaches 130/420bp.
• Whether the European BBB-A spread shifts from its current low-widening state to the significant decompression commonly seen during historical sell-off periods.
• Whether 10Y Bund yields decline, and how they perform relative to EU IG credit returns.
• Whether credit fund flows continue to reflect rotation into higher-quality assets, especially IG inflows and HY, LL outflows.