Where Credit's Due; Part II

FRI 24 JUN 2022

There has been a notable shift in the prevailing bias over the past week from inflation/rate risk to recession fear. While aggregate earnings remain resilient (so far) fixed income and commodity markets suddenly appear acutely focused on the downside risk. Our sense is that this is not particularly surprising given the speed and magnitude of the Fed’s tightening cycle and some of the recent macro news flow.

In that context, the US high yield market has traded remarkably well so far. While spreads have clearly widened from trough levels, the high yield index (in aggregate) is only trading at 500 basis points or around the long term average credit risk premium. To be fair, the total return on the high yield index is still down by 12.7% so far year to date. However, junk bonds have out performed investment grade credit by 3.4% (US IG is -16.1% year to date) driven by the rise in yield (decline in price) from the “risk free” component of the return. Of course, it is also important to note that lower rated credit spreads (CCC) have widened a lot more to around 900 basis points (chart 1).

As we have noted in the past, high yield bonds are comparable to a lower beta equity or analogous to the Australian beer “pure blonde” which has 80% less calories than regular beer. Nevertheless, the performance of junk bonds is driven by similar factors as equity; the earnings cycle or the capacity to service corporate debt out of cash flow, risk perceptions, volatility or the inverse of liquidity. Our fear is that the material tightening in broad financial conditions, suggests that there will be a non-trivial slowdown in growth and profits over the coming quarters. In turn, that is likely to contribute to a further reflexive or self-reinforcing widening in the credit risk premium. Note the rate of change in financial conditions based on the Goldman Sachs Index is now greater than during the pandemic in 2020 (light blue line in chart 2 below).

While corporate pricing power and profit margins are still near record levels, the best leading indicators suggest that conditions will deteriorate over the next two quarters. Moreover, it is notable that the distribution of corporate leverage is skewed. Although large S&P500 companies have record profit margins and low net debt/EBITDA, corporate debt relative to GDP (sales) for all companies (based on the national accounts profits) is still elevated relative to the credit risk premium. For that reason high yield credit tends to have a skewed distribution of returns (or fat tails).

We would also note the material widening in Credit Default Swap (CDS) spreads on some of the large US homebuilders (for example, Toll Brothers and KB Homes) that are likely vulnerable to the sharp rise in mortgage rates and slowdown in the US housing market (CDS spreads on the homebuilders are approaching 2020 peak levels).

In conclusion, if growth, profits and corporate cash flow (the capacity to repay debt) remain strong, spreads don’t necessarily widen during the early central bank tightening cycle phase or when policy remains accommodative relative to neutral. However, the challenge in this episode is that central banks are tightening into a slowing growth environment and that risk compensation in junk bonds is only back to the long term average (around 500 basis points). Historically, spreads tend to overshoot. In this region, high yield risk compensation is considerably greater. However, it is probably too early to take on high yield credit in the US and Europe. However, if risk free rates (US Treasury yields and short term interest rate expectations start to fall) investment grade credit might start to out perform junk.