A couple of weeks ago, we pointed out that the performance of corporate bonds and equities were starting to diverge suggesting that credit spreads were reflecting risks emanating from Europe and their escalating debt crisis while stocks were focused elsewhere. Furthermore we added that an astute investor may consider moving toward a defensive posture in their corporate bond portfolio by either selling risk outright and into U.S. Treasuries, positioning on the shorter end of the corporate yield curve, rotating out of more volatile corporate sectors like Banks and Finance and into safer Industrials, or incorporating some combination of the three.
Since that time, the yield on the Barclay’s U.S. Corporate Bond Index has widened 8 basis points to a spread of 193 over comparable maturity U.S. Treasuries while the S&P 500 has significantly declined by more than 60 points or a drop of 4.5 percent. Now with the uncertainty of Greece exiting the Euro back on the table, equities have in essence caught up, to some degree depending on your view, to express risks that face many investors.
Bond Trading – Corporate Spreads & SPX
While equities are on full alert with any news from across the pond that could rock the markets, not all asset classes are taking a beating as of late. In particular, cash bonds in the High Yield sector has for the most part, held their own in recent days. The yield differential on the Barclays’s U.S. Corporate High Yield Index which covers close to two thousand non-investment grade debt, closed yesterday at 596 basis points over comparable maturity U.S. Treasuries for a month-to-date increase of just 14 basis points.
So when we compare the change between the High Grade Corporate Bond and High Yield indices, the moves by the latter is somewhat underwhelming. In other words, when High Yield has a spread that is almost three times as much as the other, one should expect a much greater change.
To quantify this, we utilize linear regression analysis over the past five years of data to gauge the appropriate change. Without going into too much statistics, we note that the multiplier (or Beta or slope) of the basis point change between the two indices should be about 2.9. So given the 8 basis point change of the high grade corporate bond sector, the High Yield index should widen by about 23 to 24 basis points. When compared to the actual recent activity of 14 basis points, it appears that cash bonds in the High Yield sector are at risk for further underperformance.
Now High Yield bulls could argue that spreads have held in simply because of fundamentals such as low historical default rates. Also, the reason for widening in High Grade corporates could be due to the fact that many companies in that sector are more exposed to Europe in terms of global business. Furthermore, the financial sector which is the epicenter of contagion risk is a larger component of the High Grade sector.
In addition, High Yield investors in the cash bond markets may have chosen not to sell in fear of not being able to re-enter the market at a later date given the limited supply due to bare inventories on Wall Street. This may be why there is a strong divergence between cash bonds and derivatives where supply and liquidity is less of a constraint in the latter in wanting to reflect a bearish view. The benchmark 5-Year High Yield Credit Default Swap (Markit CDX HY Series 18 June 2017) which is an index that consists of 100 high yield entities has widened by 95 basis points to a spread of 672.
Bond Trading – High Yield Cash Bonds & Derivatives
In any event, the fact remains that a Greek exit from the Euro could lead to contagion which is evident in rising debt yields in other peripherals such as Spain and Italy. Risks are escalating that could ultimately affect all investors in every asset class where even the strongest of disciplines may be challenged. Unfortunately, there is no analogue or blueprint of such an event of this magnitude. Even the most experienced investors cannot gauge how deep this European rabbit hole may go. We do know that rising volatility will not be kind to risky sectors like High Yield, not to mention equities. Hence and until the risks are justified, a defensive posture as mentioned a couple of weeks ago may be warranted in the coming days or weeks.