We delayed publishing the July Fixed Income Review so we can present fresh data and comment on the surge in volatility following the Fed meeting (7/31) and new tariffs on China (8/1). 

In general, the fixed income markets were mostly sleep-walking through July in anticipation of a July 31^st Federal Reserve rate cut and a much-anticipated dovish statement from the Fed.  As if on autopilot, stock markets slogged higher and credit spreads moved tighter throughout the month. Meanwhile, Treasury yields rose modestly after their dramatic declines in May and June. Indeed, as the table below reflects, Treasuries were the only major fixed-income class to lose ground on a total return basis in July. All other categories posted positive returns for the month.

In stark contrast, the ETF table below highlights some of the significant changes we have seen since the beginning of August.

Following the Federal Open Market Committee (FOMC) meeting on July 31 and the subsequent press conference delivered by Chairman Jerome Powell, the future of monetary policy was suddenly in question. For the first time in several months, the Fed failed to deliver a dovish surprise.

Part of Powell’s response to the first question in the press conference regarding the “hurdle” for further rate cuts was as follows:

“…the committee is really thinking of this as a way of adjusting policy to a somewhat more accommodative stance to further the three objectives that I mentioned. To ensure against downside risks, to provide support to the economy that those factors are pushing down on economic growth and then to support inflation. So, we do think it’ll serve all of those goals. But again, we’re thinking of it as essentially in the nature of a midcycle adjustment to policy.”

Despite the evidence and assurances of rate cuts to provide a firebreak against any potential weakening of the economy, Powell’s reference to “a midcycle adjustment” suddenly raised doubts about their conviction for further easing.  

Given the strength of the U.S. economy, the “downside risks” he refers to are clearly emanating from foreign sources. Now add a Fed that may not be ready to cut rates further and the renewed escalation of the trade war between the U.S. and China and one has a potent cocktail for the volatility seen since the end of July.

As can be seen in the tables above, fixed-income markets in July were mostly a non-event but the first several days of August have been full of fireworks. The table below illustrates the move in U.S. Treasury yields since July 31.

Investment grade and high yield markets reacted with some displeasure to Jerome Powell’s comments and new rhetoric from the administration on trade and tariff challenges associated with China. Although the magnitude of the spread changes did not breach any meaningful technical levels, the speed of the change was rather head-snapping.

We end up in a familiar place. If we are to take the Chairman at his word and potential downside risks warrant a rate cut, it becomes even more challenging to justify the valuations investors are being asked to pay to own risky assets. Despite having posted new highs in recent weeks, the S&P 500 has produced a 3.48% annualized total return over the past 18 months along with volatility of 15.5%. High yield bonds have delivered annualized total returns of 4.80% with 12.9% volatility. Net out the most recent inflation data of 1.6% from those numbers and we struggle to understand why investors have been so enthusiastic.

Eighteen months ago, one could buy 10-year Treasuries at a 2.85% yield. The 7-10 year ETF (Ticker: IEF) has delivered 3.55% total return and with only 4.4% volatility. Needless to say, while not glamorous, the risk-free route provided returns on par with stocks and high-yield but with significantly less volatility. Given the risks Chairman Powell has outlined, might Treasuries, despite near-record low yields, be the safe place to hide in fixed income for the time being? Astute, rational investors will either figure that out on their own or the market will impose its will.

All Data Courtesy Barclays

As central banks have become collectively more dovish throughout 2019, monetary stimulus appears to be back in control of the economic cycle. The Federal Reserve ratcheted up their easing posture at the June Federal Open Market Committee (FOMC) meeting as one voting member dissented from the group in favor of a rate cut. There were other non-voting members even arguing for a 50 basis point rate cut on concerns about the economic outlook and still muted inflation pressures. Keep in mind this abrupt flip in policy is coming despite unemployment at near half-century lows and inflation hovering around 2.0%, the supposed Fed target.

With that backdrop in play, it is no surprise that June was a good month for all risk assets. Within the Fixed income arena, the riskiest of bonds outperformed against the spectrum of safer fixed-income products. As the table below highlights, every major category performed well with emerging markets (EM) leading the way and investment grade (IG) and high yield (HY) corporate returns close behind.

Fixed income has now completed a “round trip” from June 2018 as yields and spreads in almost every category are back below the levels observed at the same time last year. The tables below illustrate those moves in both yields and spreads.

The anticipation of what is being called “insurance rate cuts” from the Fed as well as easing measures expected from the European Central Bank (ECB), offered investors comfort that these potential actions will keep downside risk and volatility at bay. The hope is that the central bankers are sufficiently ahead of the curve in combating weaker global growth.

Despite investor optimism about the outlook as evidenced in the first half performance, risks remain. Most notably, ongoing deceleration in trade and industrial activity could worsen and bring an end to the current record-long economic U.S. expansion. The United States is surrounded by economies that are faltering, including Canada, Australia, Europe, Japan, much of southeast Asia and, most importantly, China. The Trump trade policy agenda only adds to these risks, especially for those countries dependent on exports for economic growth.

If risks do not abate, then we should expect forceful actions from central bankers. The common response of Treasury yields and the yield curve is for the short end (out to two- or three-year maturities) to drop significantly and the long end to either hold steady or fall but much less so than short rates resulting in what is called a bullish curve steepener. As we discussed in Yesterday’s Perfect Recession Warning May Be Failing You, past episodes of rate cuts illustrate this effect.

With investors complacent, yields and spreads on risky assets back to extremely rich levels, and global trouble brewing, the pleasant by-product of recent Fed rhetoric might quickly be disrupted. If so, the gains of the first half of 2019 would become a vague memory.

Apart from slowing global trade and industrial activity, keep in mind there are plenty of other potentially disruptive issues at hand including China leverage, Brexit, the contentious circumstances between the U.S. and Iran, the Italian government fighting with the European Commission on fiscal issues, Turkish currency depreciation, on-going problems in Argentina and more.

At the moment, the Fed and the ECB appear to have the upper hand on the markets, and higher yielding asset alternatives that reward an investor for taking risk are benefiting. Still, a critical assessment of the current landscape demands that investors engage and think critically about the risk-reward trade-off under current circumstances. The Fed and the ECB are not hyper-cautious and dovish for no reason at all. There is more to the current economic dynamic than meets the passive observer’s eye.

All Data Courtesy Barclays

To quote from last month’s FI Review, “The performance for the rest of the year no doubt depends more on coupon than price appreciation as spreads are tight and headwinds are becoming more obvious…”

On the surface, it looks as though fixed income had another excellent month with the exception of the high yield (junk) sector. Year-to-date, total return gains range from between 3.5% (MBS, ABS, CMBS) to 7.3% (junk). With equity markets up 9-10% through May, bonds are, to use horse racing vernacular, holding pace and stalking. But the monthly total return data does not tell the whole story as we shall see.

To start with an important backdrop for all asset classes, the decline in yields during May was eye-catching and most notable was the sharp inversion of the 3-month to 10-year curve spread. The table below highlights yield changes for May and the curve inversion.

The graph below shows the yields on the 3-month T-bill and the 10-year Treasury note as well as the yield spread between the two. Past inversions of this curve have tended to signal the eventuality of a recession, so this is a meaningful gauge to watch.

To reference the lead quote above, we maintain that spread tightening has most likely run its full course for this cycle and performance will largely be driven by carry. That said, we offer caution as the risk of spread widening across all credit sectors is high, and May might be offering clues about what may yet come.

The first four months of the year highlighted excellent risk-on opportunities. However, with Treasury yields now falling dramatically, they seem to signal bigger problems for the global and domestic economy than had previously been considered. The Treasury sector handily outperformed all others in May and higher risk categories (Junk and EM) were the worst performers. This is a reversal from what we have seen thus far in 2019.

Summer winds are blowing in trouble from the obvious U.S.-China trade dispute but also from Italy, Brexit, Iran, and Deutsche Bank woes.

To highlight the relationship between the historical and recent month-over-month moves in the S&P 500 returns and those of investment grade and high yield bonds, the scatter chart below offers some compelling insight. The green marker on each graph is the month of April, and the red marker is May.

Investment grade bonds have less sensitivity to equity market moves (trendline slope 0.124) and, as we should expect, high yield bonds have return characteristics that closer mimics that of the stock market (trendline slope 0.474). The scales on the two graphs are identical to further stress the differences in return sensitivity.

Finally, when looking at the spread between 5-year Treasuries and investment-grade bonds (similar duration securities) versus the spread between 5-year Treasuries and high-yield bonds, the spread widening since the end of April has been telling.

The investment grade spread to Treasuries widened by .019% (19 bps) and .82% (82 bps) against junk. Netting the risk-free interest rate move in Treasuries for May reveals that the pure excess return for the investment grade sector was -1.39% and for high yield it was -2.49%.

The month of May offered a lot of new information for investors. Most of it is highly cautionary.

All Data Courtesy Bloomberg and Barclays

Tesla’s corporate debt is rated B2 and B- by Moody’s and Standard & Poors respectively. In market parlance, this means that Tesla debt is rated “junk”. This term is often a substitute way of saying “low-rated” or frequently the term “high-yield” is used interchangeably. Tesla’s bond maturing in October of 2021 pays a 4.00% coupon and has a current yield to maturity of 6.29% based on a market price of $93.625 per $100 of face value. Based on prices in the credit default swap markets, Tesla has a 41% percent chance of defaulting within the next five years.

• The upside of owning this Tesla bond is 6.29% annually
• The bond’s annual expected return, factoring in the odds of a default and a generous 50% default recovery rate, is 0.17%
• Should Tesla default an investor could easily lose half of their initial investment.

Tesla is, in many ways, symbolic of the poor risk/return proposition being offered throughout the high-yield (HY) corporate bond market. Recent strength in the HY sector has resulted in historically low current yields to maturity and tight spreads versus other fixed income classes deemed less risky. Given the current state of yields and spreads and the overall risks in the sector, we must not assume that the outperformance of the HY sector versus other sectors can continue. Instead, we must ask why the HY sector has done so well to ascertain the expected future returns and inherent risks of an investment in this sector.

In this article we’ll examine:

• What is driving HY to such returns?
• How much lower can yields on HY debt go?
• Is further spread tightening possible?
• What does scenario analysis portend for the HY sector?

All data in this article is courtesy of Barclays.

HY Returns

The HY sector, again also known as “junk bonds”, is defined as corporate bonds with credit ratings below the investment grade (IG) rating of BBB- and Baa3 using Standard and Poors and Moody’s rating scales respectively.

The table below presents returns over various time frames and the current yields for six popular fixed income sectors as well as Barclay’s aggregate fixed income composite. As shown, the HY sector is clearly outperforming every other sector on a year-to-date basis and over the last 12 months.

We believe the outperformance is primarily due to four factors.

First, many investors tend to treat the HY sector as a hybrid between a fixed-income and an equity security. The combination of surging equity markets, low HY default rates and historically low yields offered by alternative fixed-income asset classes has led to a speculative rush of demand for HY from equity and fixed income investors.

The following graph compares the performance between the HY aggregate index and its subcomponents to the S&P 500 since 2015. Note that highly risky, CCC-rated bonds have offered the most similar returns to the stock market.

The next graph further highlights the correlation between stocks and HY. Implied equity volatility (VIX) tends to be negatively correlated with stocks. As such, the VIX tends to rise when stocks fall and vice versa. Similar, HY returns tend to decline as VIX rises and vice versa.

Second, the supply of high yield debt has been stable while the supply of higher rated investment grade (IG) bonds has been steadily rising. The following graph compares the amount of BBB rated securities to the amount of HY bonds outstanding. As shown, the ratio of the amount of BBB bonds, again the lowest rating that equates to “investment grade, to HY bonds has been cut in half over the last 10 years.  This is important to note as increased demand for HY has not been matched with increased supply thus resulting in higher prices and lower yields.

Third, ETF’s representing the HY sector have become very popular. The two largest, HYG and JNK, have grown four times faster than HY issuance since 2008. This has led many new investors to HY, some with little understanding of the intricacies and risk of the HY sector.

Fourth, the recent tax reform package boosted corporate earnings overall and provided corporate bond investors a greater amount of credit cushion. While the credit boost due to tax reform applies to most corporate issuers of debt, HY investors tend to be more appreciative as credit analysis plays a much bigger role in the pricing of HY debt. However, it is important to note that many HY corporations do not have positive earnings and therefore are currently not impacted by the reform.

In summation, decreased supply from issuers relative to investment grade supply and increased demand from ETF holders, coupled with better earnings and investors desperately seeking yield, have been the driving forces behind the recent outperformance of the HY sector.

HY Yields and Spreads

Analyzing the yield and spread levels of the high yield sector will help us understand if the positive factors mentioned above can continue to result in appreciable returns. This will help us quantify risk and reward for the HY sector.

As shown below, HY yields are not at the lows of the last five years, but they are at historically very low levels. The y-axis was truncated to better show the trend of the last 30 years.

Yields can decline slightly to reach the all-time lows seen in 2013 and 2016, which would provide HY investors marginal price gains. However, when we look at HY debt on a spread basis, or versus other fixed-income instruments, there appears to be little room for improvement. Spreads versus other fixed income products are at the tightest levels seen in over 20 years as shown below in the chart of HY to IG option adjusted spread (OAS) differential.

The table below shows spreads between HY, IG, Treasury (UST) securities and components of the high-yield sector versus each other by credit rating.

The following graph depicts option adjusted spreads (OAS) across the HY sector broken down by credit rating. Again, spreads versus U.S. Treasuries are tight versus historical levels and tight within the credit stack that comprises the HY sector.

Down in Credit

As mentioned, the HY sector has done well over the last three years. Extremely low levels of volatility over the period have provided further comfort to investors.

The strong demand for lower rated credits and lack of substantial volatility has led to an interesting dynamic. The Sharpe Ratio is a barometer of return per unit of risk typically measured by standard deviation. The higher the ratio the more return one is rewarded for the risk taken.

When long term Sharpe ratios and return performance of IG and HY are compared, we find that HY investors earned greater returns but withstood significantly greater volatility to do so.  Note the Sharpe Ratios for IG compared to HY and its subcomponents for the 2000-2014 period as shown below. Now, do the same visual analysis for the last three years. The differences can also be viewed in the “Difference” section of the table.

The bottom line is that HY investors were provided much better returns than IG investors but with significantly decreased volatility. Dare we declare this recent period an anomaly?

Scenario Analysis

Given the current state of yields and recent highs and lows in yield, we can build a scenario analysis model. To do this we created three conservative scenarios as follows:

• HY yields fall to their minimum of the last three years
• No change in yields
• HY yields rise to the maximum of the last three years

Further, we introduce default rates. As shown below, the set of expected returns on the left is based on the relatively benign default experience of the last three years, while the data on the right is based on nearly 100 years of actual default experience.

Regardless of default assumptions and given the recent levels of volatility, the biggest takeaway from the table is that Sharpe Ratios are likely to revert back to more normal levels.

The volatility levels, potential yield changes and credit default rates used above are conservative as they do not accurately portray what could happen in a recession. Given that the current economic cycle is now over ten years old, consider the following default rates that occurred during the last three recessions as compared to historical mean.

Needless to say, a recession with a sharp increase in HY defaults accompanied with a surge in volatility would likely produce negative returns and gut wrenching changes in price. This scenario may seem like an outlier to those looking in the rear view mirror, but those investors looking ahead should consider the high likelihood of a recession in the coming year or two and what that might mean for HY investors.

Summary

An interest rate is the cost for borrowing money and the return for lending money. Most importantly for investors, interest rates or yields help ascertain the amount of risk investors believe is inherent in a security. When one’s risk expectation and those of the market are vastly different, an opportunity exists.

Given the limited ability for yields, spreads, volatility and default rates to decline further, we think the reward for holding HY over IG or other fixed income sectors is minimal. Not surprisingly, we believe the risk of a recession, higher yields, wider spreads, higher default rates and increased volatility carries a higher probability weighting. As such, the risk/reward proposition for HY appears negatively skewed, and chasing additional outperformance at this point in the cycle appears to be a fool’s errand.

For those investors using ETF’s to replicate the performance of the HY sector, you should also be especially cautious. As a point of reference, Barclays HY ETF (JNK) fell 33% in the last few months of 2008. A repeat of that performance or even a fraction thereof would be a high price to pay for the desire to pick up an additional 2.03% in dividend yield over an IG ETF such as LQD.

The bottom line: Markets are not adequately paying you to take credit risk, move up in credit!