We’ve marveled month after month at the resiliency of credit markets and indeed, at least a couple of strategists we’ve spoken to have said we are precisely correct in asserting that when it comes to bulletproof asset classes, credit takes the proverbial cake.
Recall this hilarious title from a Deutsche Bank note out earlier this year:
Of course the reason you’re seeing a continued grind towards post-crisis tights in IG and HY is that central banks are simply creating artificial demand by engineering a never-ending quest for any semblance of yield.
Meanwhile, in Europe, the outright purchase of corporate credit has created an overwhelming technical and as Citi’s Joseph Faith and Matt King explained in a note out Monday, the ECB has managed to replicate the pre-crisis environment wherein the proliferation of synthetic CDOs effectively created negative net supply.
Well as we’ve also been keen to remind you, the end result of all of this is that investors get driven further and further down the quality ladder until eventually, people who used to be satisfied with risk-free govies look up and find themselves doing weird shit like chasing after junk offerings and fracker IPOs.
This has been exacerbated in HY recently by a dearth of supply. That is, already tight spreads have tightened further on the strength of still strong demand against an absence of issuance (and as if you didn’t have enough to ponder, do also consider that IG has actually outperformed since March). Recall this, from a previous post:
Consider that just 22 deals priced in July for $10.6b, the lowest monthly volume since February 2016 and the lightest July since 2008, with the exception of July 2015.
Well, with more demand than supply, yields plunged to new three-year lows in July and, notably, yields fell for 10 consecutive sessions at one point during the month.
Taken to its logical extreme, all of the above suggests that HY should start to become more correlated with equity factors (although in HY Energy it’s worth noting that equities are actually leading credit in terms of predicting troubled waters ahead) and sure enough, Goldman is out on Monday confirming just that.
First is a recap of the HY market:
The curious case of low high yield spreads
While much is rightfully made of the leadership of Tech, the promise of Financials and the conundrum of Low Vol, an area to which we believe investors should pay closer attention is the High Yield (HY) space. A combination of the search for yield, lack of supply and a benign default environment has driven HY spreads to near their tights. Meanwhile, much like the VIX, these spreads are diverging versus increased Policy Uncertainty – a historically strong relationship. Further, many equity market factors are increasingly correlated with HY spreads while the options market suggests concern on the come (e.g., elevated skew versus other fixed income markets).
- TINA, at least when it comes to yield: US HY spreads have tightened 60bp in 2017 and are near the lowest level since the Great Recession. In yield terms, this equates to a yield-to-worst (YTW) of 5.5%, which is near multi-decade lows.
- Fundamentals: Leverage stretched, defaults benign: Low rates have incentivized companies to raise debt and leverage is elevated. That said, defaults have been benign at about 2% over the last year (ex Energy, Metals & Mining), which is significantly below the 30-year average of 4.7% on the back of sustained, if uninspiring economic growth.
- A word on technicals: The search for yield along with the recent lack of supply is also likely playing a role. Almost 1/3 of the YTD tightening occurred in July alone as primary market issuance was basically nonexistent ($9 bn, the 2nd slowest July since 2010).
- Equity investors are paying attention: While low yields/tight spreads indicate that credit investors do not see much risk in their market, the strong performance of our Balance Sheet factor (Low Net Debt/EBITDA vs. High) this year suggests equity investors are increasingly nervous. Notably, this has been driven by both legs of the trade working – in plain English, this mean that names with low leverage have outperformed the average stock while those with weak balance sheets have underperformed.
Right, so again, everything is now one trade and just as the rally started at the top of the quality ladder and moved down with the hunt for yield, the unwind will start at the bottom of the quality ladder and move up.
Which brings us to equity factors taking their cues from HY spreads. “We note that a number of equity factors are cueing off HY spreads as indicated by higher-than-average correlations vs. history,” Goldman writes, adding that “indeed, correlation for each of Volatility, Financial Returns, Size, Short Interest and Integrated factors is in the 90th+ %-ile relative to the last 5 years [so] net, if spreads move, these factors have the potential for dislocation in portfolios.”
And guess what? You’re seeing the skew in HYG rising steadily as investors turn to the ETF for liquid hedging:
Finally (and this is the chart everyone loves to hate or hates to love, depending), here’s HY spreads becoming increasingly disconnected from the now ubiquitous Economic Policy Uncertainty Index:
So, what should you do if you start to see HY selloff? Here’s Goldman’s suggestion (and this is verbatim):
Hint: You sell growth.
And the visual to back that up: