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.
Our prior article, "High-yield rotation trade appears to have further upside," explored a possible high-yield analogy to the hotly debated prospect of a Great Rotation from Growth to Value in the equity market. In this week's piece we show how the industry rotation trade we proposed on Nov. 24 has worked out. We conclude that the mode of analysis that produced the rotation recommendation shows promise as an alpha generator in future situations.
Recap of our proposed industry rotation trade
From the 2020 pandemic-induced equity market low on March 23 through Nov. 6, the S&P 500 Growth Index (SGX) walloped the S&P 500 Value Index (SVX) by a total return margin of 69.91% to 43.05%. Over the next two weeks, however, Value turned the tables, beating Growth to the tune of 5.33% to -0.94%. Our Nov. 24 piece searched for an analogous rotation among high-yield industry groups. Those investigations disclosed that from the 2020 high-yield low on March 23 through Nov. 6, the two top-performing major high-yield industries were Energy and Gaming. Both industries repeated their index-beating performance over the next two weeks. On the other hand, the next two highest-performing industries from March 23 through Nov. 6, Metals & Mining and Automotive & Auto Parts, underperformed the ICE BofA US High Yield Index's 1.09% return over Nov. 6 – Nov. 20 period.
We further found that three minor industries fulfilled the role played by Value stocks in the equity market's rotation. All three beat Metals & Mining and Automotive & Auto Parts from March 23 to Nov. 6 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 united the three newly buoyant industries — Air Transportation, Leisure, and Entertainment & Film — which we dubbed the ALE group. They were all huge beneficiaries of the eventual end to social distancing that fully approved vaccines promised to hasten.
More important than the recap of previous performance was the question of whether the ALE industries possessed further relative return upside. As detailed in the Nov. 24 report, we found that despite dramatically outperforming Metals & Mining during the Nov. 6 – Nov. 20 interval, all three ALE industries remained at extremes (in the cheap direction) versus Metals & Mining in option-adjusted spread, or OAS, terms, relative to their 2019 daily mean OAS differentials. (We used Metals & Mining in this spread matchup rather than Automotive & Auto Parts because a change in average rating during the analysis period reduced its validity as a basis of comparison.)
We concluded that investors who expected further progress on the COVID-19 vaccination front had a continuing opportunity to add alpha by replacing selected Automotive & Auto Parts and Metals & Mining issues with bonds of three industries that particularly stood to benefit. They were Air Transportation, Leisure, and Entertainment & Film. We cautioned that normal caveats applied, notably the likelihood of interim setbacks. Our analysis, however, found remaining upside in the rotation trade and that the strategy was feasible to implement.
How did the rotation trade work out?
The chart below documents that the recommended rotation trade worked out quite favorably. Over a period of less than two months, an equally weighted portfolio of the three ALE industries rated ADD TO beat an equally weighted portfolio of the two industries rated REDUCE by 95 basis points. The ADD TO group's highest-return (Air Transportation) and lowest-return (Leisure) industries beat their highest-return (Metals & Mining) and lowest-return (Automotive & Auto Parts) counterparts in the REDUCE group. Paralleling these high-yield results, the S&P 500 Value Index continued to outperform the S&P 500 Growth Index in the Nov. 20, 2020, to Jan. 15, 2021 interval, 7.66% to 4.72%.
Is there still juice in the trade?
Following the same logic employed in our Nov. 20 analysis, we show in the chart below that the rotation trade still has the potential to generate alpha. Even after strongly outperforming Metals & Mining and Automotive & Auto Parts from Nov. 20, 2020, to Jan. 15, 2021, the ALE industries remained at extremes to the cheap side versus the Metals & Mining reference spread. Investors who expect the reopening of the economy to progress further over the course of 2021 should continue to favor the ALE group.
Entertainment & Film's June 2020 reduction in Composite Rating from B2 to B3 slightly complicates the picture for that industry. In our judgment, however, the wide disparity between its historical and current valuations nevertheless justifies its continued inclusion in the favored group. As for Automotive & Auto Parts, it widened by 48 bps of option-adjusted spread versus Metals & Mining between Nov. 20 and Jan. 15. Going forward, in our view, deemphasis should focus more on Metals & Mining than on Automotive & Auto Parts. As in our Nov. 24 piece, we note that although the sector rotation trade remains attractive, it may experience interim periods of unfavorable results.
We are encouraged by the results of our Nov. 24 rotation trade recommendation. The methodology consisted of adapting a sector strategy from the equity market to high-yield and corroborating the trade's potential by comparing relative spreads with spreads of a historical base period. This approach is likely to have additional applications in the future. We will be on the outlook for such opportunities.
High-yield valuations remain overwhelmingly beholden to Fed intervention
The ICE BofA US High Yield Index's option-adjusted spread (OAS tightened to +386 bps on Dec. 31, 2020, from +433 bps on Nov. 30, 2020. Our Fair Value estimate of the spread meanwhile dropped to +943 bps from +982 bps. The gap between the actual spread and our Fair Value estimate consequently worsened slightly to -557 bps from -549 bps. As depicted in the chart below, the high-yield asset class remains extremely overvalued by conventional standards. Conventional standards are somewhat beside the point, though, as long as extraordinary Fed intervention in financial markets in response to the COVID-19 epidemic dominates the valuation of high-yield bonds.
December's decrease in the Fair Value estimate reflected improvements in Capacity Utilization, to 74.5% from 73.3%, and Industrial Production, to 1.6% from 0.4%. The percentage of banks tightening credit standards minus the percentage easing standards is reported just once a quarter and consequently remained at 37.7 percentage points. Also unchanged, at 0.36%, was the five-year Treasury yield, which is inversely correlated with the spread. The default rate, a backward-looking indicator with only a minor impact on the spread, nominally increased to 6.6% from 6.2%. Our dummy variable for quantitative easing remained at 1, indicating that the monetary tool, unused between 1951 and 2008, remains in place. The huge prevailing gap between the actual spread and our Fair Value estimate is attributable to financial market support that goes well beyond quantitative easing.
These conclusions 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 US 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 an extreme valuation 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 chart above.
Research assistance by Lu Jiang and Zhiyuan Mei.
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