Shrugging off economic growth, inflation and U.S. Treasury supply concerns that seem to have plagued the fixed-income markets for the past few months, most bond sectors staged a healthy rally in July as performance reflected the risk-on flavor for the month. The riskiest sectors, emerging markets and high yield (HY), performed best while the safest, Treasuries and mortgages, were the only two sectors to post monthly losses.
Anxieties surrounding trade and tariffs were overshadowed by comments from the Federal Reserve (Fed) that were broadly very constructive for the U.S. economy. In his quarterly testimony to Congress, Fed Chairman Powell emphasized a favorable outlook due to strong labor markets and the lift from fiscal policy stimulus. Those positives outweighed the downside risk emanating from rising protectionism.
Year-to-date, only the high-yield sector is in the black, municipals are essentially flat and every other sector is posting a negative return. Although much improved in July, emerging market bonds continue to struggle but with good reason given the political and foreign exchange disruptions in many places like Turkey, Argentina, Brazil and South Africa. Somewhat strangely, the divergence between high yield and investment grade (IG) corporates persists as they represent the best and the worst performers of the year so far.
Reviewing the lower rated corporate bonds in the IG and HY corporate sectors offers an illustration of the extent to which lower-rated high yield bond valuations have outperformed lower-rated IG.
The chart above highlights the yield-to-worst (YTW) relationship between BBB-rated IG bonds and CCC-rated HY going back to the end of the recession in June 2009. To get back to the average trendline would require the CCC YTW to increase to approximately 10.75% from the current 8.39% yield. If we assume a five-year duration, such a move would entail an approximate price decline of 12%.
In terms of spread, CCC’s would need to move higher by 100 basis points to 6.50 or the BBBs would need to drop by roughly 50 basis points.
In our opinion it is worth looking into a trade whereby you are long BBB’s and short CCC’s. What makes this idea even more compelling is the comparative credit risk advantage. According to S&P ratings analysis, roughly 40% of CCC-rated bonds will default within 3 years while the risk to BBB-rated bonds is less than 2%.
Michael Lebowitz, CFA is an Investment Analyst and Portfolio Manager for RIA Advisors. specializing in macroeconomic research, valuations, asset allocation, and risk management. RIA Contributing Editor and Research Director. CFA is an Investment Analyst and Portfolio Manager; Co-founder of 720 Global Research.