High Yield Credit: The Case for Staying Overweight (Despite Tight Spreads)

FIDA 202104 High Yield curve v2

High Yield Credit: The Case for Staying Overweight (Despite Tight Spreads)

Chris Watling, Longview Economics

As the US and global economic recovery appears increasingly assured, and with plenty of good news therefore in the price, many are now highlighting the downside risks to markets. 

In particular, valuations have become extreme; signs of retail participation and speculative excess in markets are growing; portfolio managers are taking on record levels of ‘above average’ risk1; with many now turning their attention to the threat of high, and perhaps persistently high, inflation. Indeed, as of last month, ‘inflation’ overtook ‘the pandemic’ as the top tail risk currently facing markets1. There is, therefore, much concern that Fed/central bank largesse is coming to an end.

With high yield (HY) credit spreads back at reasonably tight levels (i.e. relatively expensive), therefore, the key questions are: How strong is the case for staying overweight credit? How much more can spreads tighten? And, having already tightened considerably in recent months, what might compress them further (or, at least, keep them tight)? 

FIDA 202104 High Yield Credit Image 1

Recent price action in credit markets, in that respect though, is encouraging for the bulls. In particular, with the uptrend in bond yields accelerating in Q1, and with the US rates market pricing in a 25bps hike (by 2023), high yield spreads have continued to compress. Driving that compression, the Merrill Lynch High Yield bond yield broke below a key resistance level in November (of 5.8%) on the vaccine news; falling to its lowest level on record (since 1985). In other words, the improving outlook for growth has been the key driver of price action in the credit market (rather than the prospect of tighter monetary policy). 

Likewise, in Europe, HY credit spreads have also compressed. Interestingly, while the US HY credit spread is back at/testing multi-year lows (see figure 1 below), the Eurozone HY credit spread is still relatively wide. Currently it’s at 315bps, and not yet back at its lows from 2018 (236bps) or 2007 (206bps). Disaggregating the components of that spread, the Eurozone HY yield, on a stand-alone basis, has trended lower this year and is testing its low from November 2017 (2.8%), reflecting, in that respect, the notably low German Bund yields.

Fig 1: US high yield corporate bond spreads (bps, with 50 & 200 day trend lines)

FIDA 202104 High Yield Credit Chart 1

Source: Longview Economics, Macrobond

The resilience/strong performance of HY credit should persist in coming months and quarters, for three key (related) reasons:

1. Most importantly, the corporate sector is structurally robust and, as a result, corporate sector risk is low/falling. Reflecting that, key market-based barometers of corporate sector risk premia should therefore also trend down/stay low. Of particular note, the corporate sector’s cash flow position is healthy. This is illustrated by the financing gap, shown in figure 2, which measures the free cashflow of the US ‘economy-wide’ corporate sector (i.e. of both public listed and private companies). When companies run a large cashflow deficit they rely heavily on externally generated sources of cash. At that point, they become overstretched and vulnerable (e.g. to shocks/tighter money) and the chance of a recession significantly increases. All recessions post Bretton Woods have begun when the corporate sector has had a large cashflow deficit. When there’s a surplus, though, or when the deficit is small (as it is currently), then corporate sector risk, and recession risk, is low. 

Fig 2: US corporate financing gap (% of GDP)

FIDA 202104 High Yield Credit Chart 2
 Source: Longview Economics, Macrobond

At those times of strong cashflow, which is typical in the early stages of the economic cycle, companies have the capacity and appetite to invest, increase activity, re-build inventories, increase hiring and so on (all of which ultimately feeds back into stronger earnings and adds to corporate sector health/strength). Of note in that respect, and consistent with the rapid vaccine rollout that’s underway in the US, CEO confidence has risen to its highest reading since 1983 (see figure 6). Animal spirits have therefore meaningfully returned to the corporate sector. In addition, companies are increasing activity, with stronger capital expenditure (e.g. core durable goods orders); more hiring (e.g. increasing job openings); and a rebuilding of inventory (the uptrend in ISM Manufacturing Index).

2. Reflecting all of that, a renewed phase of low/falling equity volatility is emerging. Of note, a sustained fall in volatility is typical in the early stages of new economic expansions and is consistent with an environment of tightening credit spreads (i.e. as markets price in low/falling corporate sector risk). As we show in figure 4, credit spreads and equity volatility are highly correlated.

Typically, that phase of falling risk premia persists for the first half of the economic cycle, or at least until the Fed begins to tighten monetary policy. In the past three economic expansions, for example, equity market volatility continued to fall (at least) until a new Fed policy tightening cycle had begun (figure 3). In the mid-1990s and mid-2000s, the uptrend in volatility started with a Fed rate hike. In the last cycle it began once the ‘shadow’ Fed funds rate started to move higher (i.e. as a result of tapering), see figure 3.

Fig 3: S&P500 implied volatility (VIX, %), shown with US recessions

FIDA 202104 High Yield Credit Chart 3

Source: Longview Economics, Macrobond

With the VIX breaking down (below a key technical level) in March (figure 4), volatility is therefore behaving normally for this stage of the cycle (and is starting to confirm the recent tightening of credit spreads). Key measures of corporate sector risk premia are therefore likely to fall (or stay stable), probably until Fed tapering begins. 

Of interest, European equity market volatility is behaving in a similar way to that of the US. The VDAX, for example, which measures implied volatility for the German stock market, broke below a key level in March (i.e. 21.9%, which was a key technical support level from November 2020 to February this year).

3. In that respect, the case for low/falling volatility, and tightening credit spreads, is enhanced by the Fed’s dovish policy stance and the likelihood that asset purchases will probably continue for some time. In particular, the Fed has deliberately positioned itself behind the curve (i.e. it’s planning to let the economy ‘run hot’). That stance has been made clear in recent Fed press conferences, statements, and speeches (by various Fed Presidents), and was summarised by Bullard earlier this month:

…So what we want to do here is, as the boom occurs and the pandemic comes to a close, hopefully, we’ll get more inflation than we’re used to and we’ll allow some of that to flow through to inflation expectations, re-centre inflation expectations at the 2% target, and this will improve credibility that we really mean it when we say we going to hit 2% inflation, and we really are going to hit that, on average, over time. So we’ll probably let inflation run above average for some time. And then, only after all that happens, will we look at policy normalisation.

Source: James Bullard (FOMC voter this year & St. Louis Fed President), interview with CNN Business News, 1st April 2021

In other words, once higher inflation from base effects has ‘rolled out’ over the next few months2, the Fed then plans to allow inflation to run above target and, even when that happens, it will be allowed to occur ‘for some time’. That will make up for the inflation ‘misses’ of the past and increase/change inflation expectations. Only then does the Fed plan to ‘normalise’ policy.

Compared to the prior economic cycle, therefore, the speed of the Fed’s response to growing inflationary pressures is likely to be much slower. All of that supports the case for an ongoing compression of risk premia in markets.

Fig 4: Implied US equity volatility (VIX, %) vs. US high yield credit spreads (pp.)  

FIDA 202104 High Yield Credit Chart 4

Source: Longview Economics, Macrobond

4. On top of that, and in the near term, a counter trend rally in US Treasuries is underway (i.e. with yields moving lower, and Treasury prices moving higher). Often, although not always, phases of falling US 10 year yields are associated with a rally in the credit market (i.e. as spreads remain stable, or indeed compress). In this instance, we expect the rally in Treasuries to be accompanied by the ‘pricing out’ of Fed rate hikes (which is the usual correlation between bond yields and interest rate expectations). 

Usually, counter trend rallies in Treasuries last at least until bearish positioning and sentiment in bonds has largely unwound. In 2017, the counter trend rally lasted for nine months. Currently, though, bearish sentiment is extreme (see figure 5), with a rally in Treasuries likely to support the credit market, at least over coming months.

Fig 5: Bond sentiment vs. 10 year bond yield (NB scale INVERTED%)

FIDA 202104 High Yield Credit Chart 5

Source: Longview Economics, Macrobond

Risks to this thesis are multiple and should be considered. These include the potential for surprisingly high inflation prints over coming months, which forces the Fed to start changing its policy stance sooner than it would otherwise (i.e. bringing forward the timing of tapering/tightening). 

Other risks include a possible setback on the health front, including the ongoing emergence of new virus strains (with the potential that some of those strains are more deadly/infectious and cannot be fought effectively with the current vaccines). A fiscal policy mistake is also possible (i.e. if it is tightened too quickly). Of note, and linked to that, higher US/global corporation tax rates, if they are enacted, will probably put upward pressure on key measures of corporate sector risk premia (i.e. volatility and credit spreads). Of interest in that respect, the reverse was true in 2017 in anticipation of the Trump corporate tax cuts (with the VIX, for example, falling to its lowest level on record). 

Fig 6: CEO confidence (own business vs. the economy), Conference Board data

FIDA 202104 High Yield Credit Chart 6

Source: Longview Economics, Macrobond

Overall, taking the outlined risks into consideration, there remains a strong case to expect credit spreads to either remain tight, or tighten further in coming months. That case is built on (i) the robust (and strengthening) health of the US corporate sector; and linked to that (ii) the ongoing compression of corporate sector risk premia (and the downtrend in volatility); which is typical in the early stages of new economic cycles and, historically, has persisted in environments of (iii) loose Fed policy. 

 

1 According to recent BAML Fund Manager Surveys.
2 With the Fed (and others) expecting a ‘transitory’ increase in inflation over coming months.
Disclaimer 
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