U.S. High Yield Credit Spreads: Unmoved?

Mid Week Bond Update

U.S. High Yield Credit Spreads: Unmoved?

As U.S.dollar Libor continued to rise, average high yield credit spreads have yet to rise; overall fixed-income volatility has been relatively unmoved by the action in equities.


As trade and tech tumult continued, U.S. dollar Libor continued to rise – along with the U.S. overnight swap rate. Together, that drove the net cost of borrowing (i.e. the spread between the two rates) to 0.59075%, a level not seen since the depths of the 2007-09 financial crisis. But this rise appears unrelated to the heightened volatility in equities. A more likely explanation has to do with the supply side of the equation. With the U.S. government’s need to borrow increased along with the latest deficit-fed budget, issuance of short-dated Treasuries has driven up both the supply and expectations of future issuance, leading yields higher.  Corporations, for their part, are also seeing their borrowing rates for commercial paper rise, with the impact on profitability yet to be seen.

But Libor – the benchmark that refuses to die – may have met its match.  On Tuesday, the New York Fed launched its Secured Overnight Financing Rate (SOFR), a market-based method of measuring the cost of borrowing cash overnight collateralized by Treasury securities. Like Libor, SOFR will be reported once daily. But the key difference from Libor lies in its dependence on the prices of transactions as reported by the clearing houses through which they run, rather than on verbally-reported borrowing rates.  SOFR for April 2, 2018 was 1.80%.
 

On the Slide? U.S. Corporate HY Spreads

The U.S. Treasury yield curve continued to flatten this past week, generating much talk of recession– despite substantial evidence to the contrary, Fed mistakes notwithstanding. One way of testing the recession hypothesis is to look at credit spreads for high-yield corporates, arguably the sector most sensitive to the prospects of cash-flow related distress. For comparison over a meaningful credit cycle, it also makes sense to look as far back as a year before the global financial crisis of 2007.

Unmoved: Average corporate HY credit spreads remain low, for now

Source: Bloomberg, April 2, 2018. Left and right scales are in basis points, scale for bottom panel is in percent. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

One interpretation of this chart is that the HY credit spreads appear unworried about potentially deteriorating business conditions, despite the continuing compression of term spreads. A second observation is that current conditions don’t resemble the 2006-7 period, when short rates were relatively stable and substantially higher than they are now, and credit spreads were substantially lower

But the credit spread is an average of several subsectors of the HY market.  One subsector, BBB-rated corporate debt, has indeed risen. From a low on Feb 2, 2018 of 1.09%, the spread has risen to 1.36%, suggesting that the subsector may have detected something in the wind.
 

On the Rise: Correlations; An unusual First Quarter in U.S. Munis.

 

Correlation contagion? Not so much

Since the Global Financial Crisis a decade ago, diversification has gotten a bad rap, in some cases deservedly so. Investors expecting protection from all-encompassing market meltdowns saw correlations across asset classes go to 1.0 just when hopes for uncorrelated returns were highest.

But during this past year, as equity volatility has resumed after a multi-year absence, volatility hasn’t crossed over to fixed income, at least so far.

Bear minimum: Correlations of volatility

Source: Bloomberg, April 2, 2018. Left and right scales are in basis points, scale for bottom panel is in percent. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

Correlations are by their nature backward-looking. This chart shows the correlation over the previous 40 trading days, nearly two months.  So the most recent figure, 0.0493, might not adequately capture the most recent upticks in either, or both asset classes.

It’s also important to note that this is correlation of volatility, not correlation of returns. So in addition to the standard cautions about correlations, these findings only apply to volatility – the roughness of the ride – rather than returns – where you’re heading.

Nevertheless, after a jittery few months in the equity markets, finding a spot of relative tranquility can be welcome.

A Puerto Rico Bond Story

Looking behind the stunning Bloomberg headline about investors reaping “95% gains on Defaulted Puerto Rican Bonds”[1] reveals a relatively thinly-traded $3.5 billion face-value general obligation bond with a coupon of 8% that was issued at 93 in March 2014, scheduled to mature on July 1, 2035. Hurricane Maria struck Puerto Rico in September 2017, making a bad credit situation even worse. On January 2, 2018, just over $301 million in interest payments due to bondholders were not made, putting the bond into default.

Not your average Muni

Source: Bloomberg, April 3, 2018. Left and right scales are in basis points, scale for bottom panel is in percent. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

The gain referenced in the article may or may not be hypothetical for any single owner, since about $5 million was traded on December 14, 2017 and $2 million on April 3, 2018. If the buyers at the bottom were also the sellers at the top, that would account for the roughly 95% gain referenced in the article. The face value of the trades was about 0.06% of the total face value of the issue.

The conclusion: Whether the rise in price of these bonds is due to an improvement in general economic conditions, a possible belief in recovery assistance from the Trump budget, or just a trader’s fluke, it makes good sense to consider the risks involved before concluding that this was so-called “easy money”.

 


[1] Source: Bloomberg Markets website, April 3, 2018: "Stunned Investors Reap 95% Gains on Defaulted Puerto Rico Bonds"

 

The London Interbank Offered Rate (Libor) is the interest rate determined daily by a specific group of London banks for deposits of certain stated maturities.  Libor is used as a base index for setting rates of some adjustable rate financial instruments, including Adjustable Rate Mortgages (ARMs)

A spread is the difference in yield between two different types of fixed income securities.

Correlation is a statistical measure of the relationship between two sets of data. When asset prices move together, they are described as positively correlated; when they move opposite to each other, the correlation is described as negative or inverse. If price movements have no relationship to each other, they are described as uncorrelated.

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High yield bonds are subject to increased risk of default and greater volatility due to the lower credit quality of the issues.

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