Tag Archives: BBB

Digging For Value in a Pile of Manure

A special thank you to Brett Freeze of Global Technical Analysis for his analytical rigor and technical expertise.

There is an old story about a little boy who was such an extreme optimist that his worried parents took him to a psychiatrist. The doctor decided to try to temper the young boy’s optimism by ushering him into a room full of horse manure. Promptly the boy waded enthusiastically into the middle of the room saying, “I know there’s a pony in here somewhere!”

Such as it is with markets these days.

Finding Opportunity

These days, we often hear that the financial markets are caught up in the “Everything Bubble.” Stocks are overvalued, trillions in sovereign debt trade with negative interest rates, corporate credit, both investment grade, and high yield seem to trade with far more risk than return, and so on. However, as investors, we must ask, can we dig through this muck and find the pony in the room.

To frame this discussion, it is worth considering the contrast in risk between several credit market categories. According to the Bloomberg-Barclays Aggregate Investment Grade Corporate Index, yields at the end of January 2020 were hovering around 2.55% and in a range between 2.10% for double-A (AA) credits and 2.85% for triple-B (BBB) credits. That means the yield “pick-up” to move down in credit from AA to BBB is only worth 0.75%. If you shifted $1 million out of AA and into BBB, you should anticipate receiving an extra $7,500 per year as compensation for taking on significantly more risk. Gaining only 0.75% seems paltry compared to historical spreads, but in a world of microscopic yields, investors are desperate for income and willing to forego risk management and sound judgment.

As if the poor risk premium to own BBB over AA is not enough, one must also consider there is an unusually high concentration of BBB bonds currently outstanding as a percentage of the total amount of bonds in the investment-grade universe. The graph below from our article, The Corporate Maginot Line, shows how BBB bonds have become a larger part of the corporate bond universe versus all other credit tiers.

In that article, we discussed and highlighted how more bonds than ever in the history of corporate credit markets rest one step away from losing their investment-grade credit status.

Furthermore, as shared in the article and shown below, there is evidence that many of those companies are not even worthy of the BBB rating, having debt ratios that are incompatible with investment-grade categories. That too is troubling.

A second and often overlooked factor in evaluating risk is the price risk embedded in these bonds. In the fixed income markets, interest rate risk is typically assessed with a calculation called duration. Similar to beta in stocks, duration allows an investor to estimate how a change in interest rates will affect the price of the bond. Simply, if interest rates were to rise by 100 basis points (1.00%), duration allows us to quantify the effect on the price of a bond. How much money would be lost? That, after all, is what defines risk.

Currently, duration risk in the corporate credit market is higher than at any time in at least the last 30 years. At a duration of 8.05 years on average for the investment-grade bond market, an interest rate increase of 1.00% would coincide with the price of a bond with a duration of 8.05 to fall by 8.05%. In that case a par priced bond (price of 100) would drop to 91.95.

Yield Per Unit of Duration

Those two metrics, yield and duration, bring us to an important measure of value and a tool to compare different fixed income securities and classes. Combining the two measures and calculating yield per unit of duration, offers unique insight. Specifically, the calculation measures how much yield an investor receives (return) relative to the amount of duration (risk). This ratio is similar to the Sharpe Ratio for stocks but forward-looking, not backward-looking.

In the case of the aggregate investment-grade corporate bond market as described above, dividing 2.55% yield by the 8.05 duration produces a ratio of 0.317. Put another way, an investor is receiving 31.7 basis points of yield for each unit of duration risk. That is pretty skinny.

After all that digging, it may seem as though there may not be a pony in the corporate bond market. What we have determined is that investors appear to be indiscriminately plowing money into the corporate credit market without giving much thought to the minimal returns and heightened risk. As we have described on several other occasions, this is yet another symptom of the passive investing phenomenon.

Our Pony

If we compare the corporate yield per unit of duration metric to the same metric for mortgage-backed securities (MBS) we very well may have found our pony. The table below offers a comparison of yield per unit of duration ratios as of the end of January:

Clearly, the poorest risk-reward categories are in the corporate bond sectors with very low ratios. As shown, the ratios currently sit at nearly two standard deviations rich to the average. Conversely, the MBS sector has a ratio of 0.863, which is nearly three times that of the corporate sectors and is almost 1.5 standard deviations above the average for the mortgage sector.

The chart below puts further context to the MBS yield per unit of duration ratio to the investment-grade corporate sector. As shown, MBS are at their cheapest levels as compared to corporates since 2015.

Chart Courtesy Brett Freeze – Global Technical Analysis

MBS, such as those issued by Fannie Mae and Freddie Mac, are guaranteed against default by the U.S. government, which means that unlike corporate bonds, the bonds will always mature or be repaid at par. Because of this protection, they are rated AAA. MBS also have the added benefit of being intrinsically well diversified. The interest and principal of a mortgage bond are backed by thousands and even tens of thousands of different homeowners from many different geographical and socio-economic locations. Maybe most important, homeowners are desperately interested in keeping the roof over their head

In contrast, a bond issued by IBM is backed solely by that one company and its capabilities to service the debt. No matter how many homeowners default, an MBS investor is guaranteed to receive par or 100 cents on the dollar. Investors of IBM, or any other corporate bond, on the other hand, may not be quite so lucky.

It is important to note that if an investor pays a premium for a mortgage bond, say a 102-dollar price, and receives par in return, a loss may be incurred. The determining factor is how much cash flow was received from coupon payments over time. The same equally holds for corporate bonds. What differentiates corporate bonds from MBS is that the risk of a large loss is much lower for MBS.

Summary

As the chart and table above reveal, AAA-rated MBS currently have a very favorable risk-reward when compared with investment-grade corporate bonds at a comparable yield.

Although the world is distracted by celebrity investing in the FAANG stocks, Tesla, and now corporate debt, our preference is to find high quality investment options that deliver excellent risk-adjusted returns, or at a minimum improve them.

This analysis argues for one of two outcomes as it relates to the fixed income markets. If one is seeking fixed income credit exposure, they are better served to shift their asset allocation to a heavier weighting of MBS as opposed to investment-grade corporate bonds. Secondly, it suggests that reducing exposure to corporate bonds on an outright basis is prudent given their extreme valuations. Although cash or the money markets do not offer much yield, they are always powerful in terms of the option it affords should the equity and fixed income markets finally come to their senses and mean revert.

With so many assets having historically expensive valuations, it is a difficult time to be an optimist. However, despite limited options, it is encouraging to know there are still a few ponies around, one just has to hold their nose and get a little dirty to find it.

Steepening Yield Curve Could Yield Generational Opportunities : Michael Lebowitz on Real Vision

On July 1st, Michael Lebowitz was interviewed by Real Vision TV. In the interview he discussed our thoughts on the yield curve, corporate bonds, recession odds, the Federal Reserve, and much more. In particular, Michael pitched our recent portfolio transactions NLY and AGNC, which were both discussed in the following RIA PRO article: Profiting From a Steepening Yield Curve.

Real Vision was kind enough to allow us to share their exclusive video with RIA Pro clients. We hope you enjoy it.

To watch the Video please click HERE

Goldman Sachs on Corporate Debt: Myopic or Self-Serving?

The biggest problem that most people have is that they read Wall Street research reports and they believe the Wall Street hype… Wall Street analysts are very, very easy to fool, they’re generally parrots for what management tells them.” – Sam Antar, former CFO Crazy Eddie

In 2018, Goldman Sachs underwrote 513 corporate debt issuance deals totaling $94.5 billion. They were paid an average fee of 0.48% or approximately $453.6 million for those efforts.

In a recent research report entitled, Corporate Debt Is Not Too High, Goldman Sachs discusses why they are not concerned with the current levels of corporate debt despite record levels of corporate debt when compared to the nation’s GDP as shown in the chart below.

Goldman’s argument cites the following four reasons:

  1. Corporate debt remains below the 2001 peak as a share of corporate cash flows and has declined as a share of corporate assets
  2. Lower interest rates and more stable cash flows, which help reduce the cost of debt, mean that equilibrium leverage is likely higher than most of the post-war period
  3. Corporate debt in aggregate has a longer maturity which has reduced the refinancing risk
  4. The corporate sector runs a financial surplus which implies that capital expenditures are less dependent on external financing and less vulnerable to a profit squeeze

As discussed in our article The Corporate Maginot Line, not only have corporate debt levels risen dramatically since the financial crisis, but the quality of that debt has declined markedly. With the post-crisis recovery and expansion, the full credit spectrum of corporate debt levels are significantly larger, but debt outstanding in the single-A (A) and triple-B (BBB) rating sectors have grown the most by far.

Unlike previous periods, the composition of corporate debt within the investment grade sector is now heavily skewed toward the riskiest rating category of BBB. BBB-rated securities now represent over 40% of all corporate bonds outstanding. Additionally, all sorts of other risky loans reside as liabilities on corporate balance sheets and are potentially toxic assets for banks and investors. Most notable are leveraged loans extended to businesses by banks to corporations.

Beyond the amount of debt outstanding, another consideration related to creditworthiness are the uses of cash raised by corporations via debt issuance. Have the proceeds been used productively to enhance the future earnings and cash flows of the company, thereby making it easier to service the debt, or have they been used unproductively, creating a financial burden on the company in the future?

In A Perfect World

In an environment where the economy continues to grow at 2% and interest rates remain low, corporations may be able to continue borrowing at the pace required to fund their operations and conduct share buybacks as they wish. The optics appear sound and, based on linear extrapolation of circumstances, there is no reason to believe that tomorrow will differ from yesterday. However, if things do change, this happy scenario being described by the analysts at Goldman Sachs may turn out to be naively optimistic and imprudent.

Let us consider Goldman’s four points one at a time:

  1. Corporate debt remains below the 2001 peak as a share of corporate cash flows and has declined as a share of corporate assets

Corporate debt as a share of cash flow may not be at the 2001 peak, but it is higher than every other instance since at least 1952. As seen in the chart below, this measure tends to peak during recessions, which makes sense given that cash flows weaken during a recession and debt does not budge. This argument is cold comfort to anyone who is moderately aware of the late cycle dynamics we are currently experiencing.

Using corporate debt as a share of corporate assets as a measure of debt saturation suffers from a similar problem. The pattern is not as clear, but given that the value of corporate assets tends to decline in a recession, this metric does not offer much confidence in current conditions. While not at or above prior peaks, debt as a share of corporate assets appears somewhat elevated relative to levels going back to 1952. Unlike debt as a share of cash flow, this metric is not a helpful gauge in anticipating downturns in the economy.

  • Lower interest rates and more stable cash flows, which help reduce the cost of debt, mean that equilibrium leverage is likely higher than most of the post-war period

Goldman’s claim is purely speculative. How does anyone know where the “equilibrium leverage” level is other than by reflecting on historical patterns? Yes, interest rates are abnormally low, but for them to continue being an on-going benefit to corporations, they would need to continue to fall. Additionally, those “stable cash flows” are an artifact of extraordinary Fed policy which has driven interest rates to historical lows. If the economy slows, those cash flows will not remain stable.

  • Corporate debt in aggregate has a longer maturity which has reduced the refinancing risk

This too is a misleading argument. Goldman claims that the percentage of short-term debt as a share of total corporate debt has dropped from roughly 50% in 1985 to 30% today. The amount of corporate debt outstanding in 1985 was $1.5 trillion and short-term debt was about $750 billion. Today total corporate debt outstanding is $9.7 trillion and short-term debt is $2.9 trillion. The average maturity of debt outstanding may be longer today, but the nominal increase in the amount of debt means that the corporate refinancing risk is much bigger now than it has been at any time in history.

  • The corporate sector runs a financial surplus (income exceeds spending) which implies that capital expenditures are less dependent on external financing and less vulnerable to a profit squeeze

According to Federal Reserve data on corporate financial balances, the corporate sector does currently have surplus balances that are above the long-term average, but the chart below highlights that those surpluses have been declining since 2011. The recent boost came as a result of the corporate tax cuts and is not likely to be sustained. Historically, as the economic cycle ages, corporate balances peak and then decline, eventually turning negative as a precursor to a recession. If corporate financial surpluses continue to erode, capital expenditures are likely at risk as has been the case in most previous cycles.

Summary

In a recent speech, Dallas Fed President Robert Kaplan stated that the high ratio of corporate debt to U.S. GDP is a concern and that it “could be an amplifier” if the economy turns down. A few days later, Fed Chairman Jerome Powell echoed Kaplan’s comments but followed them by saying, “today business debt does not appear to present notable risks to financial stability.”

“Today” should not concern Chairman Powell, tomorrow should. In that speech, entitled Business Debt and Our Dynamic Financial System, Powell contrasts some key characteristics of the mortgage crisis with current circumstances in corporate lending and deduces that they are not similar.

Someone should remind the Chairman of a speech former Chair Ben Bernanke gave on October 15, 2007, to the Economic Club of New York. Among his comments was this:

“Fortunately, the financial system entered the episode of the past few months with strong capital positions and a robust infrastructure. The banking system is healthy.”

That was exactly 12 months prior to Congress passing legislation to bailout the banking system.

As we suspected, you do not have to search too hard to find a Goldman Sachs report downplaying the risk of subprime mortgages in the year leading up to the subprime crisis.

In February 2007, Goldman penned a research report entitled Subprime Mortgage: Bleak Outlook but Limited Impact for the Banks. In that report, after elaborating on the deterioration in the performance of subprime mortgages, Goldman states, “We expect limited impact of these issues on the banks as bank portfolios consist almost entirely of prime loans.” Goldman followed that up in October 2007 publishing a report on financial crisis poster child AIG titled, Weakness related to possible subprime woes overdone.

Goldman Sachs and their competitors make money by selling bonds, being paid a handsome fee by corporate counterparties. Do not lose sight of that major conflict of interest when you read reports like those we reference here.

Even though it rots teeth and contributes to diabetes, Coca-Cola will never tell you that their soft drink is harmful to your health, and Goldman et al. will never tell you that corporate bonds may be harmful to your wealth if you pay the wrong price. Like most salespeople, they will always hype demand to sell to investors.

Banks will continue to push product without regard for the well-being of their clientele. As investors, we must always be aware of this conflict of interest and do our homework. Bank and broker opinions, views, and research are designed to help them sell product and make money, period. If this were not true, there never would have been a subprime debacle.

The Corporate Maginot Line

Since the post-financial crisis era began more than a decade ago, record low-interest rates and the Fed’s acquisition of $4 trillion of the highest quality fixed-income assets has led investors to scratch and claw for any asset, regardless of quality, offering returns above the rate of inflation. 

Financial media articles and Wall Street research discussing this dynamic are a dime-a-dozen. What we have not heard a peep about, however, are the inherent risks within the corporate bond market that have blossomed due to the way many corporate debt investors are managed and their somewhat unique strategies, objectives, and legal guidelines. 

This article offers insight and another justification for moving up in credit within the corporate bond market. For our prior recommendation to sell junk debt based on yields, spreads, and the economic cycle, we suggest reading our subscriber-only article Time To Recycle Your Junk. If you would like access to that article and many others, you can sign up for RIA Pro and enjoy all the site has to offer with a 30-day free trial period. 

Investor Restraints

By and large, equity investors do not have guidelines regulating whether or not they can buy companies based on the strength or weakness of their balance sheets and income statements. Corporate bond investors, on the other hand, are typically handcuffed with legal and/or self-imposed limits based on credit quality. For instance, most bond funds and ETFs are classified and regulated accordingly by the SEC as investment grade (rated BBB- or higher) or as high yield (rated BB+ or lower). Most other institutions, including endowments and pension funds, are limited by bylaws and other self-imposed mandates. The large majority of corporate bond investors solely traffic in investment grade, however, there is a contingency of high-yield investors such as certain mutual funds, ETFs (HYG/JNK), and other specialty funds.

Often overlooked, the bifurcation of investor limits and objectives makes an analysis of the corporate bond market different than that of the equity markets. The differences can be especially interesting if a large number of securities traverse the well-defined BBB-/BB+ “Maginot” line, a metaphor for expensive efforts offering a false line of security.

Corporate Bond Market Composition

The U.S. corporate bond market is approximately $6.4 trillion in size. Of that, over 80% is currently rated investment grade and 20% is junk-rated.This number does not include bank loans, derivatives, or other forms of debt on corporate balance sheets.

Since 2000, the corporate bond market has changed drastically in size and, importantly, in credit composition. Over this period, the corporate bond market has grown by 378%, greatly outstripping the 111% growth of GDP.  The bar chart below shows how the credit composition of the corporate bond market shifted markedly with the surge in debt outstanding. 

As circled, the amount of corporate bonds currently rated BBB represents over 40% of corporate bonds outstanding, doubling its share since 2000. Every other rating category constitutes less of a share than it did in 2000. Over that time period, the size of the BBB rated sector has grown from $294 billion to $2.61 trillion or 787%.

The Risk

To recap, there is a large proportion of investment grade investors piled into securities that are rated BBB and one small step away from being downgraded to junk status. Making this situation daunting, many investment grade investors are not allowed to hold junk-rated securities. If only 25% of the BBB-rated bonds were downgraded to junk, the size of the junk sector would increase by $650 billion or by over 50%. Here are some questions to ponder in the event downgrades on a considerable scale occur to BBB-rated corporate bonds:  

  • Are there enough buyers of junk debt to absorb the bonds sold by investment-grade investors?
  • If a recession causes BBB to BB downgrades, as is typical, will junk investors retain their current holdings, let alone buy the new debt that has entered their investment arena?
  • Will retail investors that are holding the popular junk ETFs (HYG and JNK) and not expecting large losses from a fixed income investment, continue to hold these ETFs?
  • Will forced selling from ETF’s, funds, and other investment grade holders result in a market that essentially temporarily shuts down similar to the sub-prime market in 2008?

We pose those questions to help you appreciate the potential for a liquidity issue, even a bond market crisis, if enough BBB paper is downgraded. If such an event were to occur, we have no doubt someone would eventually buy the newly rated junk paper. What concerns us is, at what price will buyers step up?  

Implied Risk

Given that downgrades are a real and present danger and there is real potential for a massive imbalance between the number of buyers and sellers of junk debt, we need to consider how close we may be to such an event. To provide perspective, we present a graph courtesy of Jeff Gundlach of DoubleLine.

The graph shows the implied ratings of all BBB companies based solely on the amount of leverage employed on their respective balance sheets. Bear in mind, the rating agencies use several metrics and not just leverage. The graph shows that 50% of BBB companies, based solely on leverage, are at levels typically associated with lower rated companies.

If 50% of BBB-rated bonds were to get downgraded, it would entail a shift of $1.30 trillion bonds to junk status. To put that into perspective, the entire junk market today is less than $1.25 trillion, and the subprime mortgage market that caused so many problems in 2008 peaked at $1.30 trillion. Keep in mind, the subprime mortgage crisis and the ensuing financial crisis was sparked by investor concerns about defaults and resulting losses.

As mentioned, if only a quarter or even less of this amount were downgraded we would still harbor grave concerns for corporate bond prices, as the supply could not easily be absorbed by traditional buyers of junk.   

Recommendation

Investors should stay ahead of what might be a large event in the corporate bond market. We recommend corporate bond investors focus on A-rated or solid BBB’s that are less likely to be downgraded. If investment grade investors are forced to sell, they will need to find replacement bonds which should help the performance of better rated corporate paper. What makes this recommendation particularly easy is the fact that the current yield spread between BBB and A-rated bonds are so tight. The opportunity cost of being wrong is minimal. At the same time, the benefits of avoiding major losses are large. 

With the current spread between BBB and A-rated corporate bonds near the tightest level since the Financial Crisis, the yield “give up” for moving up in credit to A or AA-rated bonds is a low price to pay given the risks. Simply, the market is begging you not to be a BBB hero.

Data Courtesy St. Louis Federal Reserve

Summary

The most important yet often overlooked aspect of investing is properly recognizing and quantifying the risk and reward of an investment. At times such as today, the imbalance between risk and reward is daunting, and the risks and/or opportunities beg for action to be taken.

We believe investors are being presented with a window to sidestep risk while giving up little to do so. If a great number of BBB-rated corporate bonds are downgraded, it is highly likely the prices of junk debt will plummet as supply will initially dwarf demand. It is in these types of events, as we saw in the sub-prime mortgage market ten years ago, that investors who wisely step aside can both protect themselves against losses and set themselves up to invest in generational value opportunities.

While the topic for another article, a large reason for the increase in corporate debt is companies’ willingness to increase leverage to buy back stock and pay larger dividends. Investors desperate for “safer but higher yielding” assets are more than willing to fund them. Just as the French were guilty of a false confidence in their Maginot Line to prevent a German invasion, current investors gain little at great expense by owning BBB-rated corporate bonds.

The punchline that will be sprung upon these investors is that the increase of debt, in many cases, was not widely used for productive measures which could have strengthened future earnings making the debt easier to pay off. Instead, the debt has weakened a great number of companies.

Fixed Income Review – April 2019

The positive trends of the first quarter extended into April with broad-based total return gains across nearly every major fixed-income category. Only the safest corners of the bond markets posted negative returns last month, albeit those losses were quite minor in contrast with the positive returns since the end of 2018.

Returns in April, across the spectrum of indices, were not as impressive as those seen in the first three months of the year. No one expected those types of moves nor would anyone, having enjoyed them, expect them indefinitely. The performance for the rest of the year no doubt depends more on coupon than price appreciation as spreads are tight and headwinds, especially in credit-sensitive sectors, are becoming more obvious as we will discuss below.

As mentioned, the only two modest losers in April were Treasuries and securitized products (mortgages, asset-backeds, and commercial mortgages). Otherwise, the high yield sector again won the day head and shoulders above investment grade corporates, the next closest performer. According to the heat map below, like last month, all sectors are green across all longer time frames adding emphasis to the impressive rally seen since Christmas.

We would not speculate on the likelihood of this trend continuing, as odds favor a weaker performance trajectory. That does not mean poor performance, but risks rise with prices and spreads perched at historically tight levels.

The charts below illustrate the option-adjusted spreads (OAS) for the major categories in the corporate universe. They have all tightened dramatically since the end of the year. If we are correct that the spread tightening is largely done, then the preference would be to play for safety, and some interest carry for the next few months. In doing so, one may miss another unexpected move tighter in very risky high yield bond spreads; however, given current spread levels, one may also avoid increased odds of poor performance and possible losses.

Understanding that compounding wealth depends on avoiding large, damaging, emotional losses we would prefer to accept the risk of lower returns with high-grade securities while reducing our exposure to the riskier, more volatile sectors.

Although cheapening more dramatically than the Investment Grade (IG) sector in the fourth quarter, High Yield (junk) bonds recaptured much of that in the first four months of this year and in doing so returns junk bonds to (more than) full-value status.

The same can also be said for the lower credit sectors within the IG population. A long-term perspective offers proper context for where valuations are today relative to the past 25 years. The risk is clearly skewed to wider credit spreads and cheaper valuations (losses).

The Trend Continues

The recent tightening of spreads offers little new to discuss other than some deceleration of price and spread action. Importantly, and as recent articles have emphasized, this is a very late stage cycle rally. Risks are rising that corporate margin headwinds, slowing global economic activity, and a high bar for rate cuts given the optical strength of the economy limit the scope for price and spread gains in credit.

Overweighting lower rated credit sectors of the fixed income market is currently akin to the well-known phrase “picking nickels up in front of a steam roller.”

All Data Courtesy Barclays

Time To Recycle Your Junk

Invariably, investors who disregard where they stand in cycles are bound to suffer serious consequences” – Howard Marks

If you believe, as we do, that the current economic cycle is likely at a similar point as 2006/07, then you should consider heeding the warning of the charts we are about to show you.

The current economic cycle stretching from the market peak of 2006/07 to today started with euphoria in the housing markets and investors taking a general indifference towards risk-taking. In 2008, reality caught up with the financial markets and desperation fueled sharp drawdowns, punishing many risky assets. The recovery that began in 2009 has been increasingly fueled by investor enthusiasm. While the stock market gets the headlines, this fervor has been every bit as evident in the junk bond sector of the corporate fixed- income markets.

Has This Cycle Reached Its Tail illustrated how investor sentiment and economic activity has evolved, or cycled, over the last 12 years. We recommend reading it as additional background for this article.

The Popularity of Junk

Junk debt or non-investment grade securities also known as high yield debt will be referred to as “junk” for the remainder of this article. They are defined as corporate debt with a credit rating below the investment grade threshold (BBB-/Baa3), otherwise known as “triple B.”

Historically, buyers of junk debt were credit specialists due to the need for an in-depth understanding of the accounting and financial statements of companies that bear a larger risk of default. Extensive analysis was required to determine if the higher yield offered by those securities was enough to cushion the elevated risk of default. The following questions are just a small sample of those a junk investor would want to answer:

  • Will the company’s cash flow be sufficient to make the payments on the debt?
  • If not, what collateral does the company have to support bond holders?
  • What is the total recovery value of plant, property and other capital represented by the company?
  • Does the yield on the junk bond offer a reasonable margin of safety to justify an investment?   

Since the financial crisis, the profile of the typical junk investor has changed markedly. Gone are the days when the aforementioned specialized analysts, akin to accountants, were the predominant investors. New investors, many of whom lack the skills to properly evaluate such investments, have entered the high yield debt arena to boost their returns. We believe that many such investors are ill-prepared for the risk and volatility that tend to be associated with non-investment grade bonds when the economic cycle turns.

The advent of exchange-traded funds (ETF’s) has made investing in junk-rated debt much easier and more popular. It has opened the asset class to a larger number of investors that have traditionally avoided the sector or simply did not have access due to investment restrictions. ETF’s have turned the junk market into another passive tool for the masses.

The combination of investors’ desperate need for yield along with the ease of investing in junk has pushed spreads and yields to very low levels as shown below. While a yield of 6.40% may seem appealing versus Treasury bonds yielding little more than the rate of inflation, consider that junk yields do not factor in losses due to default. Junk default rates reached double digits during each of the last three recessions. A repeat of those default rates would easily wipe out years of returns. Even in a best-case scenario, an annual 2.5-3.5% default rate would significantly reduce the realized yield. The graph below charts yields and option-adjusted spread (OAS).

OAS measures the spread, or additional yield, one expects to receive versus investing in a like maturity, “risk-free” U.S. Treasury bond. It is important to note that spread is but one measure investors must consider when evaluating prospective investments. For example, even if OAS remains unchanged while Treasury yields increase 300bps, the yield on the junk bond also increases 300bps and produces an approximate 15% price decline assuming a 5-year duration.

Junk Debt Spreads (OAS) and Economic Data

Economic activity and corporate profits are well -correlated. Given the tenuous nature of companies in junk status, profits and cash flows are typically extremely sensitive to economic activity. The following graphs illustrate current valuations and guide where spreads may go under certain economic environments. The label R² in the graph is a statistical measure that calculates the amount of variance of one factor based on the other factor. The R², of .58 in the graph below, means that 58% of the change in OAS is due to changes in real GDP.

In the scatter plot below, each dot represents the respective intersection of OAS and GDP for each quarterly period. Currently, as indicated by the red triangle, OAS spreads are approximately 175 basis points too low (expensive) given the current level of GDP. More importantly, the general upward slope of the curve denotes that weaker economic activity tends to result in wider spreads. For instance, we should expect OAS to widen to 10% if a recession with -2.00% growth were to occur.

The following are scatter plots of OAS as contrasted with PMI (business confidence/plans) and Jobless Claims (labor market).  The current OAS versus the dotted trend line is fair given the current level of PMI and Jobless Claims. However, if the economy slows down resulting in weaker PMI and rising jobless claims, we should expect a much higher OAS. Note both graphs have a significant R².

As discussed earlier, frothy equity markets and junk spreads have rewarded investors since the financial crisis. The scatter plot below compares OAS to CAPE10 valuations. A return to an average CAPE (16) should result in an OAS of nearly 10. Assuming that such an event was to occur, an investor with a five-year junk bond could lose almost 30% in the price of the bond assuming no default. Default would harm the investor much more.

We finish up with a similar graph as we presented in Has This Cycle Reached Its Tail. A special thank you to Neil Howe for the idea behind the graph below.

The graph, using two year averages compares the U.S. Treasury yield curve and junk OAS. The yield curve serves as a proxy for the economic cycle. The cycle started with the blue triangle which is the average yield curve and OAS for 2006 and 2007. As the cycle peaked and the financial crisis occurred, the yield curve widened, and junk OAS increased significantly. Starting in 2009, recovery took hold resulting in a flattening yield curve and lower junk OAS. The current one month point denoted by the red dot shows that we have come full circle to where the cycle began over ten years ago.

Trade Idea

Given the unrewarding risk-return profile of junk bonds, we recommend investors consider reallocating from junk to investment grade corporates, mortgages or U.S. Treasuries. For those more aggressive investors, we recommend a paired trade whereby one shorts the liquid ETF’s (HYG/JNK) and purchases an equal combination of investment grade corporates (LQD) and U.S. Treasuries (IEI).

Had one put on the paired trade mentioned above in 2014, when junk yields were at similar levels, and held the trade for two years, the total return over the holding period was 16.75%. Similarly, such a trade established in January of 2007 and held for two years would have resulted in an approximate total return of nearly 38.85%.

Investment return data used in pair trade analysis courtesy of BofA Merrill Lynch US high yield and Corporate Master Total Return Indexes. Treasury data from Barclays.

Summary

Junk debt is highly correlated with economic activity and stock market returns. When potential default rates are considered with signs that the economic cycle is turning, and extreme equity valuations, investors should be highly attuned to risks. This is not to say junk bond holders will suffer, but it should raise concern about the amount of risk being taken for a marginal return at best.

If you have owned junk debt for the last few years, congratulations. You earned a return greater than those provided by more conservative fixed-income investments. That said, we strongly recommend a critical assessment of the trade. Math and historical precedence argue that the upside to holding junk debt is quite limited, especially when compared to investment grade corporate bonds that offer similar returns and expose the investor to much less credit risk.

At RIA Advisors, we have sold the vast majority of our junk bond holdings over the last month. We are concerned that the minimal spread over Treasuries does not nearly compensate our clients enough for the real risk that the current economic cycle is coming to an end.

Fixed Income Review – March 2019

The first quarter of 2019 offered one of the most powerful surges in risky asset valuations seen in history. Closing at 2506 on December 31, 2018, the S&P 500 proceeded to rise 328 points (14.37%) to 2834 in the first quarter. The near vertical leap skyward corresponds directly to the abrupt change in posture from the Federal Reserve (Fed) as they eliminated all threats of rate hikes in 2019. They took the further step of announcing a schedule to halt quantitative tightening (QT).

As might be expected, high yield credit was the best performing sector for the quarter with a total return of 7.26%. Somewhat counter-intuitively, U.S. Treasuries (+2.11%) also rallied for the quarter although they lagged all other major fixed-income sectors as shown in the table below.

For March, risk markets stalled slightly after the big run in the prior two months. Although posting returns of nearly 1%, high yield was the worst performer while investment grade was the best.

The contrast in performance between high-quality and low-quality bonds may be telling. In what could be a related issue, interest rate volatility in the U.S. Treasury market as measured by the MOVE Index spiked higher mid-month and had implications for the credit markets.

As shown in the tables below, only the BBB spread tightened slightly with all others widening by 1-3 basis points. Putting it together, despite solid total returns for the month, the spread widening tells us that corporate credit did not keep pace with falling Treasury yields in March, particularly at the end of the month.

From a macro perspective, the changes in Treasury yields and the yield curve raise broad concerns. Namely, are we nearing the end of the current expansion? As discussed in far more detail in our prior article, Yesterday’s Perfect Recession Warning May Be Failing You, the yield curve has a durable track record of signaling major changes in the economic cycle especially when it inverts (longer-term interest rates drop below short-term rates). When an inverted curve is considered with the end of a Fed rate hike cycle, the evidence becomes even more compelling. The Fed abruptly altered their outlook for monetary policy in March putting to rest any concern for further hikes. The market is now pricing for 1 or 2 rate cuts in 2019.

The last time we observed this combination of circumstances, an inverted curve and a market implying fed funds rate cuts, was ominously in late 2006. In October of last year, when the yield curve spread was decidedly positive, most economists including National Economic Council director Larry Kudlow pointed to this barometer and said we were nowhere near recession. The current market narrative now claims we should not pay too much attention to this important historical precedent. As opposed to trying to shape the narrative to suit our interests, we prefer instead to heed history. The odds are that this time is not different.

Time will tell.

All data sourced from Bloomberg and Barclays