Fridson: What capitulation really looks like

This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to Leveraged Commentary & Data.

In the first 15 days of July, the ICE BofA US High Yield Index posted an abysmal -11.03% total return. The index’s 36-year history shows only one year with a return that low (2008, during the Great Recession, which came in at -26.39%). It would be quite reasonable for market participants to expect the high-yield market to be in disarray following a debacle of the magnitude observed in this month’s first half. One might also expect to hear sales pitches along the lines of, “It’s ridiculous how cheap some of this paper is! Rock solid credits are trading like distressed bonds.” In short, one might expect the “They’ve thrown the baby out with the bathwater” notion to take hold, implying that the market has experienced a capitulation.

Even in normal times, plausible cases can be made that selected high-yield credits are misunderstood and consequently misvalued. Some short-dated issues that have recently widened much more than their peers may very well deserve to be called money good and deemed to offer attractive total returns through maturity, notwithstanding possible volatility en route. That is very different, however, from justifying the declaration of a capitulation.

Periods of disorderly retreat from the high-yield market are typically characterized by a high distress ratio (percentage of issues in the high-yield index yielding 1,000 bps or more above Treasuries). That metric stood at 10.27% on July 15, below the December 1996 through June 2022 mean of 13.17% and only slightly above the 9.33% historical median. By contrast, the table below shows peaks of 25.74% or higher in past market cycles.         

According to the methodology described in "High-yield market's default rate forecasting record," the present distress ratio indicates a market-implied default rate forecast of 4.6%. Moody’s U.S. base case, speculative-grade, bond-only forecast, which is not published in the rating agency’s monthly default rate report, is probably still a bit below 4%. We do not view that minor disparity as a sign that terrified investors are greatly exaggerating prevailing default risk in their minds. More likely, the consensus economic forecast among investors is currently a touch more pessimistic than the one incorporated into Moody’s base case.

Returns on the ICE BofA US Distressed High Yield Index over the 12 months following the peak distress ratios ran as high as 118.54%. With the benefit of hindsight, it is not outlandish to suggest that at the point of maximum perceived distress, the speculative-grade category’s less stellar names were genuinely oversold. (The exception to the pattern, the -27.02% return in the 12 months following the September 2001 distress ratio peak, resulted from the highly unusual circumstance of a financial reporting crisis following close on the heels of the 2001 recession.)

Additional contrast between current high-yield conditions and a capitulation is observable from a comparison of profiles of the distressed universe on July 15, 2022, and at the monthly peak distress ratio of April 30, 2020. During that Covid-19-induced recession, BBs accounted for 13.37% of the issues that had an option-adjusted spread (OAS) of +1,000 bps or more. The comparable figure is now 0%. 

One can argue that the rating agencies are sometimes behind the curve in downgrading deteriorating credits. It strains credulity, however, to contend that at any given point a large number of BBs had an implied one-year default probability around 26.33%. That was the market-implied 12-month default rate forecast for distressed issues in April 2020, according to the methodology described in "High-yield market's default rate forecasting record." To put that number in perspective, in 2008, when Moody’s reported its highest-ever overall speculative-grade default rate of 12.09%, the Ba default rate was just 2.14%. Considering these facts, the 13.37% concentration of distressed bonds in the BB category observed in April 2020 strongly suggested that investors were dumping a lot of higher-end speculative-grade bonds without regard for their intrinsic value. In "Distressed BBs reveal overstated default risk," we found that even a 5% BB component in the distressed universe signals excessive assessment of default risk in the affected issues. The present 0% component, on the other hand, does not justify characterizing recent market action as a panicked flight to safety that has left proverbial $20 bills lying on the sidewalk in plain sight.   

The chart further shows that just 0.49% of currently distressed bonds have an OAS of +10,000 bps, versus 8.66% in April 2020. By way of explanation, +10,000 bps is a somewhat arbitrary OAS that ICE Indices, LLC assigns to bonds with dollar prices so low that their actual calculated spreads would be astronomical, potentially distorting the index-wide average. The issues so designated in April 2020 had dollar prices ranging from 0.25 to 31.5. Only one bond in the ICE BofA Index is currently at that sort of “no buyer at any price” level.

Finally, the ratio of bonds maturing within two years and priced at distressed levels is less than half that observed during the last recession — 4.39%, versus 9.98%. This suggests that there are comparatively few issuers that high-yield investors currently believe are so squeezed for liquidity that they cannot survive for another 24 months. Again, investors do not appear terror-struck, judging by market-based measures. While there may be some bona fide bargains on offer, portfolio managers should resist the siren song of a marketplace strewn with pristine credits that the fainthearted have tossed in the garbage pail.

In June, our credit availability measure, which is reported only once a quarter, was unchanged at negative 1.5, indicating that by a small margin more banks were easing than were tightening credit. To be sure, that number may shift materially in our next fair value update. Capacity Utilization nominally declined from 80.3% to 80.0%, and Industrial Production was likewise little changed, from 0.0% to -0.2%. The Moody’s default rate update was unchanged at 1.3%, but the fair value estimate is not very sensitive to this factor. The five-year Treasury yield, which is inversely correlated with the spread, rose from 2.81% to 3.00%.

As a result of June’s changes in the explanatory variables, our fair value estimate narrowed slightly, from +540 bps to +539 bps. The actual spread, on the other hand, ballooned from +422 bps to +573 bps. On June 30, consequently, the ICE BofA US High Yield Index’s actual spread was just 34 bps wider than fair value. That was a far cry from a difference of +124.5 bps, equivalent to one standard error, which would indicate that the high-yield risk premium was at an extreme in the direction of undervaluing the asset class. Moreover, by July 15 the actual spread had tightened to +539 bps, leaving it exactly at fair value. This is further evidence against any suggestion of a capitulation in high-yield, despite the horrendous return of July’s first half. 

The valuation findings summarized in the chart above are drawn from the updated methodology presented in "Fair Value update and methodology review." In brief, we find that 80% of the historical variance in the ICE BofAML U.S. High Yield Index's OAS is explained by six variables:

• Credit availability, derived from the Federal Reserve's quarterly survey of senior loan officers.
• Capacity utilization.
• Industrial production.
• Current speculative-grade default rate.
• Five-year Treasury yield.
• A dummy variable for the period covered by quantitative easing.

Each month we calculate a fair value spread based on the levels of these six variables. The extent of high-yield overvaluation or undervaluation is determined by the difference between the actual OAS and the fair value number ("estimated"). We define material under- or overvaluation as a divergence of one standard deviation (124.5 bps) or more from fair value. The monthly difference between the actual and estimated OAS is tracked in the accompanying chart.

Loans and bonds at exactly correct relative valuation
As of the end of June, the relative valuations of leveraged loans and high-yield bonds were precisely correct according to our model, described below. As illustrated in the chart below, the equalized ratings mix spread index was 1.78 in May, making bonds extremely rich versus loans. In June, the index swung all the way to 0.00, meaning that on a rating-for-rating basis, investors are demanding exactly as much compensation for risk in bonds as in loans.

Our recommendation on leveraged loans in a portfolio that also contains high-yield bonds consequently changes from Overweight to Neutral. The May 31 indication that high-yield bonds were extremely rich versus loans proved to be a good timing signal. In June, the S&P/LSTA Leveraged Loan Index trounced the ICE BofA US High Yield Index, -2.16% to -6.81%. 

Details of our relative valuation methodology for the two categories of debt appeared in "Loans vs. bonds – Determining relative value." In brief, we compare the three-year discounted spread on the S&P/LSTA Leveraged Loan Index and the OAS on the ICE BofA Merrill Lynch US High Yield Index, after first adjusting for differences in ratings mix between the two asset classes. We convert the difference in these spreads into an index geared to one standard deviation from the mean in either direction. A reading of plus 1.0 indicates that bonds are extremely rich versus loans, and a reading of minus 1.0 indicates that loans are extremely rich versus bonds. Inside those bands, we recommend neutral weightings of loans and bonds.

Research assistance by Zhuojun Lyu.

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