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.
The equity market is abuzz with rotation talk. For the past several months, CNBC talking heads have been debating ad infinitum whether leadership would pass from avidly demanded growth stocks to left-behind value shares. Announcements of progress on COVID-19 vaccines by Pfizer Inc. (Nov. 9) and Moderna Inc. (Nov. 16) vindicated, at least for the time being, the pundits who asserted that comparatively mundane “reopening stocks” would seize the reins from sexier tech names. The table below, focused on "value" and the red-hot Information Technology sector, documents a dramatic role reversal in the last two weeks, compared with the 7.5 months that followed the lows of March 23.
It may be too early to proclaim the advent of the Great Rotation from the value investing drought of the past decade. Some strategists argue that the patient approach of “buying dollars for fifty cents” has lost its potential for outperformance as Growth companies' ability to disrupt competitors has increased. In one version, the innovators' disruptive capability has been enhanced by private equity investors who enable innovators to grab market share for longer periods before they go public and consequently begin to face pressure to report GAAP profits.
Rotation's prominence in equities raises the question of parallels in high-yield and, if they exist, whether they still have potential to generate alpha or whether the horse is already out of the barn. Other analysts have already addressed this question in terms of quality tiers. It is true that the CCC & Lower component of the ICE BofA US High Yield Index decisively beat its higher-rated peers from Nov. 6 to Nov. 20. Its total return was 2.55% for the period, versus 0.59% for BB and 0.69% for B. The preceding period's return differentials were not comparable to those shown above for stocks, however. In price return terms, the CCC & Lower sector actually rose by less (+24.23%) than the BB sector (+24.67%) in the March 23-Nov. 6 interval. (Bs rose by +23.17%.) There may be juice remaining in the underweight-CCC & Lower trade, but the industry angle on rotation also merits consideration.
Industry rotation facts
The two top-performing major high-yield industries of the March 23-Nov. 6 interval repeated as benchmark beaters from Nov. 6 to Nov. 20, when the ICE BofA US High Yield Index returned 1.09%. Their respective-period returns were: Energy (53.28% and 2.76%) and Gaming (41.10% and 1.65%). On the other hand, the next two highest-performing industries following the March 23 low, Metals & Mining and Automotive & Auto Parts, underperformed the 1.09% benchmark return over the subsequent two weeks.
As the table further discloses, three minor industries fulfilled the role played by Value stocks in the recent equity rotation. All three beat the March 23-Nov. 6 standouts by 3.5 percentage points or more in a span of just two weeks after underperforming the same two industries by 12 percentage points or more in the earlier period. Furthermore, a theme unites Air Transportation, Leisure, and Entertainment & Film, which we hereby dub the ALE group. They are all huge beneficiaries of the eventual end to social distancing that fully approved vaccines would hasten.
Is there further upside in the HY rotation trade?
The data presented thus far may facilitate managers’ retrospective performance attribution in mid-November, but it would be more valuable to provide guidance on generating alpha going forward. Toward that end, let us consider whether the three resurgent industries have further upside or have already contributed all the alpha they can. The table below sheds some light on the matter.
Investors must always treat with caution historical spread analysis that involves industry subindexes. The average ratings of those subindexes are not stable, even over relatively short periods. Not only do bonds within an index get upgraded and downgraded, but the ratings mix changes as new issues and fallen angels enter the index, while others exit through default, retirement, or upgrading to investment-grade.
In the present instance, historical spread analysis is complicated by the fact that Automotive & Auto Parts had a Composite Rating of BB3 at the beginning of 2019 but stood a notch lower at BB2 on Nov. 20, 2020. To the extent that the ALE group has widened versus Automotive & Auto Parts, the widening is partly explained by an increase in the ratings gap between ALE and autos. To minimize that effect, we use as a basis of comparison in the chart above the Metals & Mining subindex, currently rated BB3, just as it was on Jan. 1, 2019.
Air Transportation traded at a yield give-up to Metals & Mining throughout 2019, averaging an option-adjusted spread (OAS) differential of -181 bps. Despite dramatically outperforming metals for the past half-a-month, airlines remained 216 bps wider than metals on Nov. 20. Based on these numbers, Air Transportation is wide by nearly four standard deviations versus Metals & Mining.
To understand how extreme the present metals/airlines OAS differential is, statistically speaking, consider a daily event for which the outcomes are normally distributed. An outcome outside the range of plus/minus four standard deviations will occur only once in every 43 years, i.e., twice in a lifetime (see note 1). High-yield spreads do not in fact form a perfect, bell-shaped curve. We nevertheless believe the present spread relationship strongly supports the case that the rotation trade of swapping metals for airlines still has upside, given further positive news on the vaccine front.
The comparisons with Leisure and Entertainment & Film are less pure, as both industries have undergone changes in Composite Rating since the beginning of 2019. Those rating changes may perhaps be viewed as canceling out, as one was an upgrade and the other a downgrade. Once again, the divergences from the mean 2019 spreads-versus-metals are quite substantial, including a staggering 15-standard-deviation divergence in the case of Entertainment. On the whole, investors should not worry unduly about comparability issues arising from changes in ratings mix.
Finally, a word about executability. As alluded to above, the ALE industries are not among the ICE BofA US High Yield Index's 20 largest by market value. With the possible exception of the very largest high-yield managers, though, it should be feasible to take a meaningful position in the ALE complex. ICE Indices lists 11 ALE issues with $1 billion or more face amount outstanding, spread across all three ALE industries.
Investors who expect further progress on the COVID-19 vaccination front have an opportunity to add alpha by replacing selected Automotive & Auto Parts and Metals & Mining issues with bonds of three industries that particularly stand to benefit. They are Air Transportation, Leisure, and Entertainment & Film. Normal caveats apply, notably the likelihood of interim setbacks. Our analysis indicates, however, that upside remains in this rotation trade and that it is feasible to implement.
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.
1. See https://en.wikipedia.org/wiki/68%E2%80%9395%E2%80%9399.7_rule