4 Jan, 2022
Fridson: Monthly high-yield recap and comment on forecasting
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.
Can 1-year high-yield total return forecasts aid the investment process?
Dealers have completed the obligatory year-ahead total return forecasting ritual. The high-yield total return forecasts reported by Bloomberg (note 1) include one of 4.4% and another in a range of 4% to 5%. If either the 4.4% proves accurate or the actual return matches the second forecast's midpoint, i.e., 4.5%, the 2022 return will be within 1 percentage point of the 2021 return of 5.36%. That degree of year-over-year performance stability is not unheard of, but it has occurred only twice — 1992 to 1993 and 1998 to 1999 — in the ICE BofA US High Yield Index's prior 33-year history. During that period, wide year-to-year swings in total return have been far more common. The range of total return divergence from the preceding year was -42.32 to +83.90 percentage points. There is a danger in forecasting of being unduly influenced by recent experience.
Note as well that the other 2022 high-yield return forecasts reported by Bloomberg vary from 3%-4% to -0.1%. If total return forecasting were as exact a science as, say, weather forecasting, expert practitioners would likely bunch together within a narrower range. As it is, investors have no reliable way to judge which forecast is likely to prove most accurate unless one of the dealers can document a record of superior forecasting accuracy over a period of at least 30 years. Thirty is the rule-of-thumb minimum number of observations needed to create a scientific sample.
MORE FRIDSON: Did credit analysis add value in 2021?
Investors can be confident that all of the dealers are putting careful thought into their forecasts. The problem is that their forecasts depend on assigning values to the factors that determine returns, all of which are themselves difficult to forecast. These determinants of return include changes in underlying Treasury yields and principal losses on bonds that deteriorate but do not default. Bloomberg's report indicates that the dealers' base case forecasts could be upended by such things as central bank policy errors, new COVID-19 variants and unexpected changes in fiscal policy. Adding to those potential stumbling blocks the inevitable model imperfections, i.e., inexactness in the mathematical formulas by which forecasters' models translate the inputs into projected returns, and no one should be shocked if the actual 2022 return lands completely outside the full -0.1% to 5% range of the aforementioned forecasts.
The annual year-ahead forecasting exercise is harmless as long as investors do not take the output literally or go overboard in basing investment decisions on the projection. On the positive side, one-year return forecasts enable money managers to reassure their clients that they are not flying blind. In some cases, those clients inappropriately liken investment managers to corporate production managers or sales executives who are expected to meet quotas, no matter what obstacles arise. As students of financial reporting know, those sales quotas are sometimes met by pulling ahead future-year sales via tricks such as channel stuffing.
Managing a high-yield portfolio is quite a different proposition from managing a business enterprise. Cracking the whip on employees has no impact on the market's meanderings. Portfolio managers may begin the year with their forecasting models spitting out a 4.5% return, but if the actual number — which is entirely outside their control — turns out to be 20%, beating the 4.5% expected return by 500 basis points with a 9.5% return will represent terrible relative performance. Under the same conditions, turning in a performance 2,000 bps below the "budgeted" 4.5%, i.e., -15.5%, will constitute a home run in a year when the actual number is -20%. In short, high-yield managers should pause to take polite notice of the dealer forecasts and then resume the essential tasks of ferreting out value and managing risk.
Long maturities hurt Treasury buyers, helped high-yield buyers
As detailed in the table below, long maturities were a curse in Treasurys in December 2021 but a blessing in high-yield, reversing the relationship observed in November.
For the most part, Treasury bond total returns decreased monotonically with maturity as the ICE BofA U.S. Treasury Index's effective yield rose from 1.12% to 1.24%. The discontinuity at the seven-year maturity resulted from a flattening of the yield curve. Effective yield rose by 20 bps in the two-year maturity but by only 7 bps at the seven-year mark. The 2 to 7 curve therefore flattened by 13 bps.
On the high-yield side, long duration proved an advantage as the ICE BofA U.S. High Yield Index's option-adjusted spread contracted from +367 bps on Nov. 30 to +310 bps on Dec. 31. High-yield's OAS thus finished the year close to its 2021 low of +301 bps observed Dec. 28.
CCC & Lower performed worst in December 2021, best for full year
If told that the high-yield risk premium contracted sharply in a given month, both students of financial theory and experienced market participants would probably guess that the riskiest issues racked up the biggest gains. Those issues would have begun the month with the highest yields, so the result logically would have been that they would record the high-yield universe's highest total returns.
So much for theory and experience! In December, as noted in the previous section, the ICE BofA U.S. High Yield Index's OAS tightened by a hefty 57 bps. The table below shows, however, that the CCC & Lower segment posted the smallest price gain and lowest total return of the three broad rating categories.
Investors were seemingly willing to go along with the idea that credit risk was diminishing in December 2021, but they were not willing to buy into the idea so fully as to apply it to issues that might actually default in the not-so-distant future. That interpretation is corroborated by December's wide total return disparity between nondistressed issues, at 1.89%, and distressed issues, at 1.25%. Naturally, investors' provisional step-up in risk tolerance could reflect the underlying fundamentals. That is to say, the rising tide of economic recovery might not be lifting all the boats, with CCC & Lower issuers being disproportionately represented among the still struggling.
Energy and Broadcasting soared from worst to best industry returns
As detailed in the table below, energy and broadcasting ranked No. 1 and No. 2, respectively, in December 2021's total return league table for high-yield's 20 largest industries. In November, the same two industries pulled up the rear at, respectively, No. 19 and No. 20. Conversely, Food, Beverage & Tobacco plunged from No. 2 in November to No. 19 in December. The latest month's worst performer, the utility industry, had the dubious distinction of displaying greater consistency, having finished at No. 14 in November.
These results at the extremes of the total return spectrum had some connection with beginning-of-period "market ratings" (option-adjusted spreads). December's top two performers were also the industries with the widest spread. Next-to-worst performer food, beverage & Tobacco, on the other hand, had the group's narrowest OAS.
As usual, the energy industry's fate rested with the prices of the commodities in which it deals. During December, the volatile Generic 1st Crude Oil, West Texas Intermediate contract soared from $66.18 to $75.21.
Broadcasting's performance received an extra boost from returns of 13.52% and 33.18% on issues of Diamond Sports Group. They began the month with industry-widest spreads of +3,786 bps and +2,259 bps. Three Sinclair Television Group Inc. issues also contributed generously to the industry's results, posting returns ranging from 5.14% to 7.71%. On Dec. 2, the company announced the multiyear renewal of National Hockey League broadcasting rights with expanded digital usage rights.
As for the last-place finisher, the utility industry took a blow from returns of -3.14% to -27.98% on five Talen Energy Supply LLC bonds. Fitch Ratings on Dec. 6, 2021, lowered its rating outlook on the issuer to negative. The agency cited a significant decline in available liquidity due to a requirement to post more cash collateral on the company's hedging positions as the result of a runup in forward power prices. Talen obtained secured financing to address that liquidity squeeze, but its leverage consequently rose.
Turning to No. 19 Food, Beverage & Tobacco, some of Kraft Heinz's issues dragged down industrywide performance with negative returns. On Dec. 8, 2021, the company's stock fell sharply as Guggenheim reduced its rating from Buy to Neutral, saying Kraft Heinz lacks pricing power. Two CCC-tier issuers, Hearthside Group Holdings, LLC and Triton Water Holdings Inc., also delivered negative returns in December.
No trifecta winners in December 2021
We define a trifecta winner as a bond located in the month's highest-return maturity basket, rating category and industry. In general, our trifecta analysis nevertheless underscores the potential for generating alpha in the high-yield market through top-down allocation decisions.
Strictly speaking, there were no trifecta winners in December 2021. The ICE BofA US High Yield Index contained no energy issue rated B with a maturity of 10 to 15 years. Two issues maturing in 2031, however, fell short of satisfying the last criterion by just a few months. The two bonds, with tickers SPH and BLKCQP, far outpaced the high-yield index's 1.88% return at 2.83% and 3.35%, respectively.
Aerospace, Leisure, and Food, Beverage & Tobacco cheapened markedly in December 2021
During December 2021, Aerospace, which has negative ratings prospects locating it to the left of zero on the horizonal axis of the chart below, rose above zero on the vertical axis. That moved the industry into the graph's northwest quadrant. Meanwhile, Leisure, which was just barely in cheap-to-its-ratings territory (above zero on the vertical axis) in November, became considerably cheaper vis-à-vis its peers in December. Notably, too, Consumer Products remained cheap to its ratings but considerably less so than in November. On the other side of the horizontal axis' zero mark, Food, Beverage & Tobacco moved up a good distance on the vertical scale, crossing from the southeast to the northeast quadrant and thereby making it cheap to its ratings. Homebuilders & Real Estate made a similar transition, but from just slightly below to just slightly above zero on the vertical axis.
With the latest changes, seven of the ICE BofA U.S. High Yield Index's 20 largest industries are cheap versus their peers on a rating-for-rating basis, even though the credit agencies say their ratings are likely to improve, on balance. Three industries are now rich versus their peers on a rating-for-rating basis even though the credit agencies say their ratings are likely to decline, on balance; see southwest quadrant.
In summary, we observe more than half of major high-yield industries (11, down from 12 in November) in "wrong" locations on the graph (southwest plus northeast quadrants). The change in distribution among the quadrants from a year ago is striking. On Dec. 31, 2020, with 17 of the 20 industries saddled with negative ratings prospects, investors flocked to industries reputed to be defensive despite prevailing rating agency opinion that they were headed for downgrading. At that time, seven industries were in the southwest quadrant versus just one in the northeast quadrant.
These conclusions are based on the methodology introduced in "New industry analysis shows defensives too tight." See the table below for each industry's latest coordinates. According to our analysis, industries located above the regression line in the preceding chart are cheap versus their peers, while those below are comparatively expensive, taking into account both their spreads, adjusted for ratings mix, and positive or negative biases in their ratings outlooks and watch listings.
In this update, we are maintaining our short-term recommendation on CCC & Lower at Neutral. Our recommendation is based on the analysis presented in "When to over- or under-weight CCC & lower issues." In December 2021, the ICE BofAML CCC & Lower U.S. High Yield Index underperformed the ICE BofA BB-B U.S. High Yield Index for third straight month after outperforming in September. Our analysis has found no statistically significant tendency, in this circumstance, for CCC & Lower issues to underperform for a fourth consecutive month.
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 is mostly a function of the ICE BofA 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 December 2021, the BB+B OAS narrowed to +267 bps, from +323 bps in November. Plugging the December BB+B OAS into our formula produces a fair value of +698 bps for the CCC & Lower index. By this measure, CCC & Lower issues were very close to their fair value on Dec. 31, 2021, with an actual OAS of +678 bps, down from +727 bps a month earlier. The differential of -20 bps between fair value and the actual spread is far less pronounced than the disparity of -102 bps a month earlier. Most significantly, though, the OAS gap remains far removed 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.
Underweighting recommendation continues for high-yield versus investment-grade
We are continuing our recommendation, instituted in March 2021, to underweight high-yield in a portfolio that also contains investment-grade corporates. During December 2021, the ICE BofA U.S. High Yield Index's OAS tightened by 57 bps to +310 bps, while its investment-grade counterpart tightened by just 5 bps, to +198 bps. At +212 bps, the OAS differential between the high-yield and the investment-grade indexes remains under the key level of +265 bps, below which we recommend underweighting high-yield. The conclusion that high-yield should continue to be underweighted is derived from the methodology introduced in "High-yield vs. investment-grade workout periods."
Global high-yield investors should remain neutral on Europe
During December 2021, the European Equalized Ratings Mix, or ERM, spread tightened by 40 bps, while its U.S. counterpart tightened by 51 bps. The differential between the two regions consequently increased to +61 bps from +50 bps. That change left European high-yield in the moderately cheap zone versus the U.S.
We recommend overweighting Europe only when it is extremely cheap versus the U.S. Accordingly, we maintain 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 high-yield
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 OAS tightened by 6.9 bps in December 2021. By contrast, the ICE BofA U.S. High Yield Index's ERM-based OAS tightened by 50.5 bps. The ERM-basis EM-minus-U.S. high-yield spread consequently ended December at +237 bps, up from +193 bps in November. That change left the EM-minus-U.S. differential in the second quartile of historical spreads. Because the second quartile does not represent an extreme EM valuation, we maintain our Neutral recommendation on emerging markets' 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.
Market-implied default rate forecast
As detailed in "High-yield market's default rate forecasting record," the market's implied 12-month forecast for the percentage-of-issuers default rate on U.S. speculative-grade bonds is derived from the following formula:
y = 0.133 times x-0.534
Where:
y = Distressed default rate
x = Percentage of issues in the ICE BofA U.S. High Yield Index with option-adjusted spreads of +1,000 bps or greater
The market-implied default rate forecast for the next 12 months is:
Distress ratio times distressed default rate
Plugging the Dec. 31, 2021, distress ratio of 1.98% into the formula produces a distressed default rate of 108.00%. This implies that some issues not currently priced at distressed level ought to be and will contribute to the default tally during 2022. Multiplying the distress ratio by the distressed default rate produces market-implied default rate forecast of 2.14%. One month earlier, the distress ratio was 2.25%, resulting in a distressed default rate of 95.36% and a market-implied default rate forecast of 2.15%. Note that the present market-implied default rate forecast of 2.14% is very close to Moody's 2.3% forecast for all U.S. speculative-grade (bonds plus loans).
Research assistance by Manuj Parekh and Weiyi Zhang.
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