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 S&P Global Market Intelligence.
Industries laid low by pandemic roared back to life on Nov. 9
Along with the Dow Jones Industrial Average, which soared by 835 points after Pfizer Inc. reported favorable results from early trials of its COVID-19 vaccine, high-yield bonds had a big day Monday, Nov. 9. Industries previously laid low by the pandemic had a great day.
Monday’s most extraordinary news was not the ICE BofA US High Yield Index’s +1.15-point gain. Impressive though that was, it represented only the eighth largest one-day price gain of 2020. The other seven were not confined to the first few days of the Fed-induced rebound from the March 23 bottom. On June 16, the index soared by 1.38 points.
More worthy of the spotlight were the most remarkable gains posted by industries previously mauled by the pandemic — Entertainment & Film at +7.41%, Air Transportation at +4.67%, Leisure at +3.43%, and Gaming at +1.93%. As the following table details, those industries were all deeper in the hole than the overall high-yield index through Nov. 6. For each of the industries covered in the table, the bigger its year-to-date drop through Nov. 6, the greater was its Nov. 9 gain.
To be sure, some issues in these industries scored huge percentage gains off low base prices. In the case of Entertainment & Film, containing just nine bonds, AMC Entertainment Holdings Inc.’s subordinated 10% notes due 2026 (composite rating: C) pulled up the average with a +106.3% gain from a price of 8 to 16.5. The same issuer’s secured 10.5% notes due 2025 (composite rating: CCC2) posted a more than respectable +19.57% gain, from 57.5 to 68.75. Entertainment & Film’s index-beating gain was not purely a function of outliers, however. All seven non-AMC issues racked up bigger gains than the all-industry index on Nov. 9.
Also attracting notice at Monday’s close was an all-time record-low effective yield of 4.76% on the ICE BofA US High Yield Index. That beat the previous record of 5.02%, set way back on … Thursday, Nov. 5. Prior to this month, the lowest-ever effective yield was 5.16% on June 24, 2014.
Investors should bear in mind that the high-yield index’s yield is exceptionally low by historical standards because the underlying Treasury yield is exceptionally low by historical standards. The Nov. 9 option-adjusted spread (OAS), at +422 bps, is far above the all-time low of +241 bps on June 1, 2007. This is not to dispute that the present spread and consequently, the yield are too low, according to historically based valuation methods. (See “High-yield overvaluation eases in September,” LCD News, Oct. 20, 2020.) This year, however, the Fed’s novel forms of market intervention have effectively abolished history.
Spread overlap masks ratings link to risk
Everybody who transacts in the high-yield market is aware that not every bond of a given speculative-grade credit rating trades at the identical spread-versus-Treasuries. Few have probably sought to quantify dispersion within rating groups, as we have done in the following chart. Each bar indicates, for the ICE BofA US High Yield Index as of Oct. 31, 2020, the widest and narrowest option-adjusted spread (OAS) among bonds within an alphanumeric composite rating category.
Note that we find a strikingly wide variance in spreads despite eliminating these large sources of dispersion:
- We display only the data for the largest capital structure priority represented in the index, namely, senior unsecured.
- Our analysis focuses on a date marked by relative calm in the high-yield market. The ICE BofA US High Yield Index’s OAS was +532 bps on Oct. 31, 2020, a little less than the December 1996 to December 2019 monthly mean of +553 bps. One would expect to find even more dispersion in a period of greater financial stress.
- We exclude from our analysis a small number of very deeply distressed issues to which the ICE Indices system assigns an OAS of +10,000 bps in lieu of a truly astronomical figure that would severely skew the average spreads of the lowest rating tiers.
- At the other extreme, we exclude a few problematic issues for which the index system displays an OAS of zero.
Even after we took these steps to avoid overstating the OAS dispersion within rating categories, the comparatively high-quality BB3 composite rating category, as constituted on Oct. 31, 2020, encompassed both Netflix Inc. 5.5% notes due Feb. 25, 2022, at +139 bps, and PBF Holding Co. 7.25% notes due June 15, 2025, at +3,225 bps.
Those extremes are probably attributable in part to ICE Indices’ composite rating system’s lumping together of the BB/Ba3 Netflix bond and the BB-/B1/B+ PBF Holding Company issue in a single BB3 category. The market may view the split-rated issue in such a pair as inherently a lesser credit than the “Double-B-across” bond. Wide dispersion is observable, however, even under the restriction of exact ratings match. At the BB-/Ba3 level, we find both XPO Logistics Inc. 6.5% notes due June 15, 2022, at +195 bps, and Hilcorp Energy I LP/Hilcorp Finance Company 5.75% notes due Oct. 1, 2025, at +724 bps.
In case anyone was wondering, both S&P Global Ratings and Moody’s have Stable outlooks on XPO Logistics, while neither agency offers an outlook or watchlisting on Hilcorp Energy I L.P./Hillcorp Finance Co. Of the 529-bps spread difference between these two issues, something on the order of 118 bps can be ascribed to the spread curve (see note 1) between 2022 and 2025. (Our calculation is based on median spreads on BB3 issues for those maturities, as of Oct. 31, 2020.) In addition, investors’ sensitivity to secondary market liquidity may shave some relative basis points off spreads on the XPO name, with an aggregate of $3.785 billion face amount outstanding, split among four issues represented in the ICE BofA US High Yield Index. The index’s three Hilcorp issues have a lesser, although by no means small, $1.6 billion face amount outstanding.
No matter how much of the dispersion can be explained by other factors, however, it is clear that investors routinely perceive vastly different credit risk in issues with the identical composite ratings. As stated above, the XPO and Hilcorp bonds are both solidly within the BB3 composite rating category yet are separated by 529 bps of OAS. That is almost as great as the mean monthly difference of 551 bps between the ICE BofA US High Yield Index’s BB and B subindexes. (We measure from the Dec. 31, 1996 inception date of OAS data.)
A consequence of the huge spread dispersion among identically rated, pari passu bonds is the remarkable overlap of observed OAS ranges of the composite rating categories depicted in the preceding chart. The bar graph tells us that a bond with an OAS of +700 bps might be located at any rating level from BB1 to CCC3. To the extent that spread variance within rating categories reflects bona fide differences in default risk, end investors must carefully examine managers’ ratings-based representations regarding risk controls. Recall that the once-booming business of collateralized bond obligations (as opposed to still-thriving collateralized loan operations) came to grief largely because managers of those vehicles deliberately chose the highest-yielding, i.e., riskiest issues within the ratings baskets that they could while still satisfying their overcollateralization requirements.
The vast spread dispersion within rating categories depicted in the chart above leads some investors to the incorrect conclusion that ratings are uncorrelated with risk, either in an absolute sense or as the market appraises it. High-yield managers do not necessarily dissuade clients from that mistaken belief. In their efforts to stave off fee erosion, the managers must dispel any notion that supporting an in-house team of expert credit analysts represents an unnecessary expense. Prospective clients wonder why such overhead is necessary since, in their minds, credit ratings entirely fulfill the role of assessing credit risk. Managers consequently have an incentive to discredit the ratings by drawing attention to like-rated bonds that trade at radically different spreads. They carefully neglect to mention that the ratings primarily address default probability and expected recovery, skating over the numerous other factors that determine a bond’s risk premium, including but not limited to those discussed above.
Any notion of a disconnect between ratings and risk is refuted by the following chart. We separate the signal from the noise by plotting, via the solid line, the Oct. 31, 2020, median spread of each composite rating level, rather than displaying the full range, as in the first chart. This presentation confirms that ratings decline as market-perceived credit risk rises.
Turning to actual credit risk, as indicated by historical default rates (dashed line), the link to ratings is once again clear. The default rate increases with each step down the rating scale. The only thing wrong with this picture is the convergence of the solid and dashed lines at CCC2-CCC3. This implies that investors are currently failing to extract a sufficient risk premium precisely where risk is greatest. If there is a disconnect, it is not between ratings and risk but between actual risk and the market’s assessment of it.
Where is the profit opportunity in this?
We are by no means the first to comment on the wide dispersion of spreads within rating categories. For example, a 2013 European high-yield research piece by M&G Investments (see note 2) pointed out that prevailing spread dispersion within rating categories was considerably greater than at an earlier date. The analyst advised readers to pursue convergence trades based on buying a bond with a widespread and selling a like-rated one with a much tighter spread.
Coming up in the very near future for our readers is a more articulated analysis. Instead of just looking at spread differences with rating categories, we take into account several of the non-rating factors discussed above that account for at least part of the observed dispersion. We then quantify, over a specified horizon, how effective a convergence strategy is within a homogeneous group of bonds that have widely varying spreads.
Research assistance by Lu Jiang and Zhiyuan Mei.
ICE BofA Index System data is used by permission. Copyright © 2020 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann Livian Fridson Advisors LLC's use of such information. The information is provided "as is" and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.
- For a discussion of the non-uniformity of spreads along the maturity spectrum, see “Spread curves by rating category” (LCD News, Oct. 25, 2017).
- See https://www.bondvigilantes.com/blog/2013/01/29/high-yield-its-pickin-time/.