Fridson: High yield versus investment grade; benefit of yield curve steepening

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.

To see why we have revised our stance on a key portfolio decision, go to "Underweighting now recommended for high yield versus investment grade," below.

Yield curve steepening points to easier credit ahead
Last month's 34-basis point steepening of the Treasury yield curve (2 to 10 years) is good news for the high-yield market, according to analysis recently presented by Richard Bernstein. The CEO/CIO of Richard Bernstein Advisors wrote last week in the Financial Times, "Historically, the Fed's Survey of Senior Bank Lending Officers (SLO) shows banks have been more willing to make loans to the real economy when the yield curve has been steeper." (see note 1)

A graph accompanying the online version of the article showed that yield-curve steepening is a lead indicator of improvements in a powerful variable in our Fair Value Model of the high-yield spread-versus-Treasuries. As explained in "Fair Value update and methodology review," our proxy for credit availability is the percentage of banks tightening credit standards for medium and large businesses, as reported by the Fed's SLO survey. It is the same series to which Bernstein refers. This factor explains a substantial portion of variance over time in the ICE BofA US High Yield Index's option-adjusted spread.

Unfortunately, the Fed conducts its survey only once a quarter, while the model's other explanatory variables are reported monthly. Information about where the credit availability series is moving in between the Fed's quarterly updates is quite useful. Therefore, changes in the shape of the yield curve bear watching by high-yield investors.

As we reported on Feb. 17 in "Oil price surge prompts Energy rally in US high yield market," the high-yield spread is currently much tighter than our Fair Value spread. Much of that shortfall is attributable to the extraordinary measures the Fed has taken to bolster the economy and support the financial markets. If historical patterns hold and the recent yield curve steepening moves our credit availability measure to a net surplus of easers over tighteners of credit standards, while other factors hold steady or improve, the gap between the actual spread and Fair Value will narrow.

MORE FRIDSON: Diversification, volatility and the optimal HY industry mix

Richard Bernstein's full FT article makes the important point that while quantitative easing has lowered businesses' long-term borrowing costs, banks' willingness to lend has been constrained by a narrow margin between their short-term borrowing costs and their long-term lending rates. "Allowing long-term rates to increase would not only begin to restrain financial speculation as risk-free rates rise," Bernstein argues, "but could simultaneously foster bank lending to the real economy."

Longest HY bonds performed best
Long maturities performed abysmally in the Treasury market in February but heroically in high-yield (see table below). The 2- to 30-year Treasury curve steepened by 30 bps, producing respective returns for those maturities of -0.04% and -7.40%. The 30-year had not performed so poorly since posting a -8.76% return in November 2016.

Meanwhile, the high-yield market demonstrated why investors must be judicious in applying conventional fixed-income analysis to bonds that former Treasury Secretary Lawrence Summers once described as "equities in drag." Even as Treasury rates increased across the full maturity spectrum, high-yield prices rose in the 1-to-3, 3-to-5, and 15+ year ranges, producing positive total returns in all cases. In the 5-to-7 year range, current yield sufficed to keep the total return positive despite a price decline.

Although prices advanced in some maturity ranges, the ICE BofA US High Yield Index as a whole posted a positive return only by virtue of its 0.46% income more than offsetting its -0.11% price return. Total return differences among the maturity baskets reflected variations in the mix of sectors and names. For example, the 7-to-10 year basket’s price decline was attributable in part to overweighting in Media, which took a beating in February, as detailed below in the table of industry returns (see Broadcasting and Cable & Satellite TV). The 10-to-15 year basket was penalized to some extent by overweighting in Telecommunications. Meanwhile, the 15+ year basket benefited hugely from its massive overweighting in the top-performing Energy industry — 32.34% of market value, versus 13.08% for the ICE BofA US High Yield Index.

Only CCC & Lower sector posted a price gain
As shown in the table below, CCC & Lower bonds recorded an impressive 0.97% price gain in February, while the BB and B segments suffered price declines. All three rating groups were in the black in total return terms, but just barely in the BBs' case. Year to date, as well, the bottom rating tier is far ahead of the other two. High-yield investors' eagerness to grab yield is demonstrated by the movement in option-adjusted spread between Dec. 31, 2020, and Feb. 28, 2021. By rating, the changes were -23 bps on BB, -16 bps on B, and -112 bps on CCC & Lower.

The lowest-rated sector's league-leading February performance was aided by returns of 9.90% to 32.57% on the 10 Energy bonds rated CC or C. In all, the CCC & Lower Energy segment returned a whopping 11.01%. By contrast, the non-Energy portion of the CCC & Lower category returned just 0.82%, but that was still good enough to beat BBs and Bs of all industries.

Energy extended its No. 1 return streak to four months
For the fourth consecutive month, Energy ranked No. 1 in total return among the 20 largest high-yield industries (see table below). At 2.38%, its return easily topped runner-up Leisure's 1.54%. Once again, soaring commodity prices fueled Energy gains. The Generic First Crude Oil, West Texas Intermediate futures jumped from $52.20 to $61.44, representing a 17.7% month-over-month gain. Reopening play, Leisure, by the way, leapt to the No. 2 spot all the way from No. 20 in January.

Broadcasting's No. 20 finish (down from No. 4 in January) was misleading. Fully 22.5% of the industry's market value was concentrated in a single name, Netflix Inc. That issuer's 10 bonds, rated Ba3/BB+ with positive outlooks from both Moody's and S&P Global Ratings, all incurred losses. Returns ranged from -0.28% on an issue maturing in 2022 to -4.91% on one maturing in 2029. In all, Netflix paper returned -3.03%. Excluding that one name, Broadcasting returned 0.45% in February, good enough to have ranked the industry No. 7 if not for its one big clunker.

Ratings outlook remains heavily skewed to negative
The chart below shows that the vast majority of high-yield's 20 largest industries continue to have negative net ratings prospects, as indicated by their location to the left of zero on the horizontal axis. Three of those industries are nevertheless decidedly expensive vis-à-vis their industry peer group on a rating-for-rating basis, as shown by their location well below zero on the vertical axis. Containers and Consumer Products are classic noncyclicals that investors are willing to accept risk premiums that otherwise appear insufficient. Technology debt currently benefits from high valuations on the equity underlying it.

Comparing February's pricing with January's, we find that Food, Beverage, & Tobacco swung from -31.15% on the horizontal scale all the way to +38.33%. That extraordinary move reflected the upgrade of prolific bond issuer Kraft Heinz Foods Co.s rating outlooks from Negative to Stable at Moody's and from Stable to Positive at Fitch. The market agrees with the rating agencies on this name, valuing its debt richer than its peers on a rating-for-rating basis. In fact, Food, Beverage & Tobacco is somewhat expensive relative to the graph's diagonal Fair Value line. That valuation probably reflects the industry's status as a classic noncyclical.

Also during February, Gaming moved from modestly cheap versus the peer group to modestly expensive. Migrating in the opposite direction, from below zero on the vertical scale to above zero, were Aerospace, Services and Utility.

These conclusions are based on the methodology introduced in "New industry analysis shows defensives too tight." See the table below for each industry's coordinates. According to our analysis, industries located above (below) the diagonal regression line in the preceding chart are cheap (expensive) versus their peers, taking into account both their spreads, adjusted for ratings mix, and positive or negative biases in their ratings outlooks and watchlists. As a result of delivering February's worst total return by a substantial margin, Broadcasting cheapened from 4.13% to 10.96% on the vertical scale. (Note that as detailed above, Broadcasting's decline was concentrated in Netflix.)

Neutral weighting still appropriate for short-term traders
Short-term traders should remain neutral on CCC & Lower issues. Our recommendation is based on the analysis presented in "When to over- or under-weight CCC & Lower issues." In February, the ICE BofAML CCC & Lower U.S. High Yield Index outperformed the ICE BofA BB-B U.S. High Yield Index for the fourth consecutive month after a period (the month of October) of producing an inferior return. Under such circumstances, our analysis has found no statistically significant tendency of CCC & Lower issues to repeat their outperformance in the following month.

Managers who followed last month's recommendation to switch from overweight to neutral on the CCC & Lower sector benefited from the bottom tier's outperformance, although less so than if they had remained overweighted. As we have consistently stated, this methodology is expected to deliver an edge over time rather than a win on every trade. Note as well that at any particular time, the appropriate strategy for long-term, value-oriented investors may differ from the recommendation produced by this shorter-term, momentum-based approach.

Value investors should remain neutral on CCC & Lower issues
We are maintaining our neutral recommendation on the CCC & Lower sector for patient, value-oriented investors. As documented in "CCC & Lower relatively cheap in rich HY market," variance in the ICE BofA CCC & Lower U.S. High Yield Index's option-adjusted spread, or OAS, is mostly a function of the ICE BofAML BB-B U.S. High Yield Index's OAS. We calculate fair value for the CCC & Lower segment using the following regression formula, with spreads denominated in basis points:

2.34 x BB+B OAS + 73.44 = Fair value of CCC & Lower

In February, the BB+B OAS narrowed to +310 bps, from +334 bps in January. Plugging the February BB+B OAS into our formula produces a fair value of +799 bps for the CCC & Lower index. By this measure, CCC & Lower issues were moderately tighter than their fair value on Feb. 28, with an actual OAS of +691 bps, down from +736 bps a month earlier. The -108 bps differential between fair value and actual spread compares with a slightly larger disparity of -119 bps a month earlier and remains far away from our one-standard-deviation threshold of -254 bps for declaring an extreme overvaluation. Accordingly, we continue to recommend a neutral weighting for the CCC & Lower sector for longer-horizon, value-oriented investors.

US distressed should remain underweighted
As detailed in "How to tell when distressed bonds are attractive," the U.S. distress ratio, defined as the percentage of issues in the ICE BofAML U.S. High Yield Index quoted at distressed levels (OAS of +1,000 bps or more), can be used to derive the market's implicit forecast of the speculative-grade default rate. The distressed default rate — conceptually, the percentage of distressed issuers that default within one year — declines as the distress ratio increases. Multiplying the distress ratio by the distressed default rate gives us the market's expected 12-month default rate.

On Feb. 28, the distress ratio was 3.41%, down materially from an already low 4.48% one month earlier. The latest ratio is far below the 1997-2019 monthly mean of 13.82%. Using the updated methodology described in "Estimating the market-implied default rate," we calculate an expected distressed default rate of 34.5%, indicating that the market is priced for a default rate of just 1.2% over the next 12 months. That compares with an implied Moody's forecast of 3.6%. We derive this estimate by multiplying Moody's U.S. bonds-plus-loans forecast of 5.6% by the 0.64 ratio of the agency's global bonds-only to global bonds-plus-loans forecasts.

At a gap of 1 percentage point or more, we conclude, based on historical analysis, that the distressed sector is likely to produce below-average returns over the coming 12 months. The present disparity of 2.4 percentage points far exceeds that threshold. Accordingly, we continue from last month our underweight recommendation for distressed debt within a high-yield portfolio.

Underweighting now recommended for high yield versus investment grade
We are changing our previous neutral recommendation to underweight on high yield in a portfolio that also contains investment-grade corporates.

During February, the ICE BofA US High Yield Index's OAS tightened by 27 bps, to +357 bps, from +384 bps. By comparison, the investment-grade ICE BofA US Corporate Index tightened by only 8 bps, to +95 bps, from +103 bps. The net impact was a 19-bps tightening of HY versus IG from an already narrow differential.

At +262 bps, the option-adjusted spread differential between the ICE BofA US High Yield Index and the investment-grade ICE BofA US Corporate Index is now under the threshold of +265 bps, below which we recommend underweighting high-yield. This conclusion is derived from the methodology introduced in "High-yield vs. investment-grade workout periods."

Underweighting still recommended on European distressed debt
As detailed in "European distressed debt fairly valued at present," the European distress ratio, defined as the percentage of issues in the ICE BofA Euro High Yield Index quoted at distressed levels (OAS of +1,000 bps or more), can be used to derive a leading indicator of the speculative-grade default rate. The distressed default rate — conceptually, the percentage of distressed issuers that default within one year — decreases as the distress ratio increases. Multiplying the distress ratio by the distressed default rate yields the market's expected 12-month default rate.

At the end of February, the European distress ratio was 2.92%, down from 3.41% one month earlier. Using the methodology described in the above-referenced Feb. 24, 2016, piece, we calculate an expected distressed default rate of 26.1%, indicating that the market is priced for a default rate of 0.8% over the next 12 months. That compares with an implied Moody's base-case forecast of 1.8%, down from 2.0% one month earlier. We derive this estimate by multiplying Moody's European bonds-plus-loans forecast of 2.8% by the 0.64 ratio of the agency's global bonds-only to its bonds-plus-loans forecasts. The market's forecast undershoots the inferred Moody's base case forecast by 1 percentage point. When the European market-implied default rate is 1 percentage point or more below the Moody's forecast, we infer from our U.S. research that the distressed sector is likely to produce below-average returns over the coming 12 months. Because the difference between the Moody's forecast and the market-implied forecast currently meets that cutoff, we are maintaining our previous underweight recommendation on European distressed debt.

Global high-yield investors should remain neutral on Europe
During February, the European Equalized Ratings Mix, or ERM, spread tightened by 21 bps, while its U.S. counterpart tightened by 23 bps. The differential between the two regions consequently increased to +23 bps, from +21 bps. That change left European high-yield in the fairly valued zone versus the U.S.

We recommend underweighting Europe only when it is extremely rich versus the U.S. Accordingly, we are maintaining our neutral recommendation on Europe within a cross-border high-yield portfolio. Europe is fairly valued when the ratings-equalized OAS differential between the ICE BofA Euro Non-Financial Constrained Index and the ICE BofA U.S. Non-Financial Constrained Index is in the range of 20.1 bps to 48.1 bps.

Our current conclusion regarding valuation derives from the ERM methodology described in "Europe-versus-U.S. valuation." The 2013 report introduced a technique for addressing the analytical challenge that Europe's high-yield market is much more heavily concentrated than its U.S. counterpart in BB issues. A direct comparison of quality spreads between the two regions mainly demonstrates that Europe's high-yield universe is less risky. It does not tell us whether investors are compensated more generously or less generously for a given level of credit risk in Europe than in the U.S. To remedy this problem, we equalize for the vast difference in ratings mix between the two regions to determine which region is trading cheaper, rating for rating.

Neutral weighting still recommended for emerging markets HY
We are continuing our neutral recommendation on emerging markets high-yield debt within a portfolio that also includes U.S. high-yield debt. On an ERM basis, the ICE BofA U.S. Emerging Markets Corporate Plus Index's ERM-based OAS tightened by 25 bps in February. Over the same period, the ICE BofA U.S. High Yield Index's ERM-based OAS tightened by 23 bps. The ERM-basis EM-minus-U.S. high-yield spread consequently ended February at +165 bps, down from +168 bps in January. That change in ERM spread left the EM-minus-U.S. differential in the third quartile of historical spreads. Because the third quartile indicates fair EM valuation, we are maintaining our neutral recommendation on emerging market high-yield debt.

The backstory on this recommendation is provided in "High-yield relative value, emerging markets versus U.S." That report introduced an analysis of relative value for emerging market corporates and U.S. high-yield. The key to this methodology is adjusting for the substantial difference in ratings mix between the ICE BofA High Yield U.S. Emerging Markets Corporate Plus Index and the ICE BofA U.S. High Yield Index. After that adjustment, the emerging markets sector invariably has a wider OAS than U.S. high-yield, but the magnitude of the differential varies widely over time. In the equity market, similarly, emerging markets are perennially accorded lower multiples than the U.S., reflecting concerns about the rule of law and corporate governance.

Leveraged loans recommendation remains at neutral
High-yield bonds and leveraged loans are currently very closely aligned in relative valuation terms. As illustrated in the chart below, the latest update of our monthly loans-versus-bonds relative value analysis shows loans to be just a touch expensive vis-à-vis bonds. At -0.11 on the vertical scale, loans on Feb. 28, 2021, were far from the extreme valuation (minus one standard deviation) that would trigger a recommendation to underweight them within a combined bond-loan portfolio. Accordingly, a neutral weighting on loans is currently recommended. On Jan. 31, 2021, the reading stood at -0.38.

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 option-adjusted spread on the ICE BofA U.S. 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 negative 1.0 indicates that loans are extremely rich versus bonds. Inside those bands, we recommend neutral weightings of loans and bonds.

Research assistance by Bach Ho and Ducheng Peng.

ICE BofA Index System data is used by permission. Copyright © 2021 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.

Notes
1. Richard Bernstein, "Fed must brush aside investor tantrums and let yield curve steepen," Financial Times (Feb. 25, 2021), p. 9.