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The Curiously Low Case Of High Yield Bond Spreads

Corporate leverage has never been higher, and policy uncertainty is extremely elevated... so it makes 'perfect' new normal sense that high-yield credit spreads have collapsed to multi-year tights. However, as Goldman Sachs notes, the extreme dislocations are starting to show some cracks (as HY ETF option skews suggest investors quietly positioning for wider spreads).

Even as leverage, both gross, net and normalized, hits all time high, Goldman sees the scramble for high yield paper (amid a lack of supply and benign defaults), represented by near record low HY spreads and yields, has never been greater.

 Here are Goldman's thoughts on the matter:

While much is rightfully made of the leadership of Tech, the promise of Financials and the conundrum of Low Vol, an area to which we believe investors should pay closer attention is the High Yield (HY) space. A combination of the search for yield, lack of supply and a benign default environment has driven HY spreads to near their tights. Meanwhile, much like the VIX, these spreads are diverging versus increased Policy Uncertainty – a historically strong relationship.

 

Further, many equity market factors are increasingly correlated with HY spreads while the options market suggests concern on the come (e.g., elevated skew versus other fixed income markets). It is against this backdrop that we showcase the extremes forming and the historical “playbook” in terms of factor performance if spreads do widen. Hint: You sell growth.

  • TINA, at least when it comes to yield: US HY spreads have tightened 60bp in 2017 and are near the lowest level since the Great Recession. In yield terms, this equates to a yield-to-worst (YTW) of 5.5%, which is near multi-decade lows.
  • Fundamentals: Leverage stretched, defaults benign: Low rates have incentivized companies to raise debt and leverage is elevated. That said, defaults have been benign at about 2% over the last year (ex Energy, Metals & Mining), which is significantly below the 30-year average of 4.7% on the back of sustained, if uninspiring economic growth.
  • A word on technicals: The search for yield along with the recent lack of supply is also likely playing a role. Almost 1/3 of the YTD tightening occurred in July alone as primary market issuance was basically nonexistent ($9 bn, the 2nd slowest July since 2010).
  • Equity investors are paying attention: While low yields/tight spreads indicate that credit investors do not see much risk in their market, the strong performance of our Balance Sheet factor (Low Net Debt/EBITDA vs. High) this year suggests equity investors are increasingly nervous. Notably, this has been driven by both legs of the trade working – in plain English, this mean that names with low leverage have outperformed the average stock while those with weak balance sheets have underperformed.

The dislocation is extreme to say the least...

 

However, there are some signs of cracks in the facade. Here is what Goldman is watching...

Factors are cueing off HY spreads: We note that a number of equity factors are cueing off HY spreads as indicated by higher-thanaverage correlations vs. history. Indeed, correlation for each of Volatility, Financial Returns, Size, Short Interest and Integrated factors is in the 90th+ %-ile relative to the last 5 years. Net, if spreads move, these factors have the potential for dislocation in portfolios. 

The upcoming legislative agenda. Historically, HY spreads moved directionally with Policy Uncertainty though similarly to the VIX, the correlation has broken down more recently.

With Debt Ceiling talks and potential tax reform on the near-term policy agenda, we see potential for this relationship to re-assert itself. As we wrote previously, there are some signs that uncertainty is weighing on corporate spending, M&A and by extension economic growth. 

Better to navigate with a compass than without. We leverage our Macro to Micro Compass to analyze which factors have historically been most sensitive to widening HY spreads.

We find that during these periods, investors gravitated towards safety and quality (e.g., solid financial returns, strong balance sheet, high integrated scores and large size).

And finally, Goldman sees evidence that investors are already positioning for wider spreads. Since the crisis, investors have increasingly used ETFs as a way to trade high yield views, with trading volume of HYG (the largest by AUM) now 3x larger than CDS.

We note that HYG skew – the difference between how much investors are willing to pay for puts vs. calls in the options market – has increased over the course of 2017 suggesting increasing nervousness.

In addition, HY skew also screens as elevated vs. most other fixed income markets.