3rd September 2019

2B or Not 2B (Free Content)

Finding value in the high yield market…

Just how much have rates driven returns in the quality end of high yield?  How much do spread returns in the Investment grade market explain returns in the BB space? Are BB’s cheap? Where could spreads go?

There has been much talk about the proportion of negatively yielding debt – even in European High Yield. Hopes are for the ECB to step in with a yield crushing solution in the coming weeks. Meanwhile, economic data has been softening, especially when you look at Germany and China.

Year to date BBs have outperformed single Bs by 192bps when looking at the Bloomberg Barclays High Yield Eur Index returning a not too shabby 9.84%. The BBB Euro Corporate AGG as returned a whopping 8.84% year to date, also outshining single Bs.

The Bloomberg Barclays Bundesrepublik Deutschland index has returned a 9.41% YTD. Who cares about credit risk??

Figure 1: Selected Stats for Eur Bloomberg Barclays Indices
Source: Bloomberg, CreditMarketDaily.com

Well – you should – especially if you are sitting on a decent year to date return. BBs are synonymous with quality, liquidity and low defaults. And yet we have seen Casino, Steinhoff, Dia and GE, to name a few, all nosedive in rating and price – credit risk is real. Liquidity is increasingly difficult to source, and gap risk has increased significantly over the past 12 months. If the name of the game is riding yields until they are negative then BBs certainly benefit from higher rate sensitivity, but from a credit standpoint are we doubling down?  Calculating the R Squared of Excess Returns against Total returns for the BBB/BB/B corporate indices tells us just how much spread performance drives returns.

Figure 2: R Squared of Excess and Total Returns and Return Summary for Eur Bloomberg Barclays Indices
Source: Bloomberg, CreditMarketDaily.com

On average 2010-2018 spread looks to explain 13.44% of IG returns, for BBs and Bs the numbers are 29.62% and 34.4% respectively. The LTM figures are much higher 29.61%, 35.92% and 45.65% for BBBs, BBs and Bs respectively This is mainly a function of including 2018’s sell-off. Looking at the Bar chart you can see that spread has a larger influence on returns in times of stress – 2011, 2015,2018.

So, having enjoyed the ride is it time to take chips off the table? From a credit standpoint earnings have yet to take a turn for the worse. However, the “known” unknowns list is long now. Trump’s ability to send Xover wider one day and tighter the next is a prime example. Systematic factors likely demand caution, with idiosyncratic risk, the risk at the heart of the High Yield market yet to be influenced by the overall economy.

The linkage between rating buckets when it comes to spread performance is significant.  Regressing weekly Excess returns of BBBs and BBs yields an R squared of 87%, and with BBs and Bs the figure is slightly lower at 80% reflecting the step up in default risk. Doing the same exercise on a total return basis the R squared regressing BBBs against BBs is much lower 37.5% compared to 77.8% for BBs vs. Bs.

Figure 3: R Squared between Rating Buckets
Source: Bloomberg, CreditMarketDaily.com

The inference is that credit risk explains a large part in the return of BBs vs. BBBs.  A key technical, demand from the “Investment Grade tourist”, is unlikely to endure in the context of spread underperformance. The Mean weekly return for BBs and BBBs 2010- to date are c. 33 and 17bps respectively, and BB excess return volatility is roughly 3x that of BBBs.

Looking at the spread ratio of BBs to BBBs it is hard to argue that BBs are cheap. The Ratio has averaged 1.97x since 2011 and currently sits at 1.7x. In the Dec-18 Sell off the ratio blew out to 2.56x. For context, this is roughly a 200bp widening relative to the BB index’s FY18 starting spread of 148. BBB spreads started the year at 68bps and ended at 148.

Figure 4: Ratio of Swap OAS for BB and BBB Eur Bloomberg Barclays Indices
Source: Bloomberg, CreditMarketDaily.com

So relative to BBBs, BBs look relatively rich and certainly the downside volatility appears to be significant enough to perhaps take some chips off the table.

When it comes to BBs vs Single Bs the decision to take chips off the table come down to your willingness to take more credit risk. Doing a similar exercise with Bs and BBs the average weekly excess returns 2011- to date are similar +33bps vs. +35bps. Volatility of returns is also closer (but not insignificant) with Bs having a volatility roughly 1.6x that of BBs.

Figure 5: Ratio of Swap OAS for B and BB Eur Bloomberg Barclays Indices
Source: Bloomberg, CreditMarketDaily.com

Looking at the spread ratio Single Bs vs. BBs the current value of 1.82x is practically the same as the 2011- to date average of 1.81x. Here the relationship looks fairly valued.

Credit selection is a somewhat consensus mantra. Given the margin for error at current spreads this makes perfect sense. Being overweight in the current environment assumes The ECB’s “Bazooka 3.0” will drive spreads tighter and yields lower, with the softness macro being more of an issue come 2020.

With 3 months to year-end and a significant YTD return and increasing uncertainty, taking some risk off is extremely tempting.

The CreditMarketDaily view is that we see further compression in High Yield vs. IG. Taking profits in BBs to rotate into Bs with positive credit momentum is a way to position for near term central bank action. Deep value – if your remit allows- is also a way to position for upside, given the nature of special situations they reduce your overall correlation with the wider market.       

An underweight vs. the benchmark assumes that “Bazooka 3.0” does not cure all and that the cyclical decline worsens ahead of expectations. Given the risk-on – risk-off volatility maintaining a neutral position locks in returns and allows for some upside assuming credit selection is good.

Below is a spread summary covering November 2010 to date for the Bloomberg Barclays indices discussed. “Distance from the wides” shows how far current levels spreads are from the wides of the range.

A friend of mine likens the High Yield Market to an elastic band – the more it is stretched the more violent the snap back. If you were holding that elastic band right now, I suspect you would be holding it as far from your face as you can manage. It might not be fully stretched yet, but it has the potential to deliver a sting. Credit selection and an avoidance of outright beta should lessen it should we get the snap.

A tightening to the lows would result in an additional 2.4%,1.93% and 2.86% for the BBB, BB and B indices respectively. What gets us there is probably a combination of ECB not disappointing, continued corporate strength, Orderly Brexit and China trade tensions easing.

Impossible? No. Improbable? Maybe. Likely? You Hope.

Figure 6: Spread Summary Eur Bloomberg Barclays Indices
Source: Bloomberg, CreditMarketDaily.com

George Flynn

George has 15+ years’ experience in credit. He's a Managing Director at Everest Research, a Deep Dive Independent High Yield Research Firm and owner of European High Yield Online. After starting his career at ECM Asset Management as a portfolio analyst, trader & senior research analyst, George was hired as a Senior Credit Analyst in the High Yield Team at Pictet, one of Europe’s largest High Yield mandates. He has a broad skill set that has allowed him to implement a Quantamental approach to credit research as well as developing and implementing in-house research and portfolio reporting solutions. You can follow him on twitter @EuroYield