This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to S&P Global Market Intelligence.
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High-yield bonds all but defined "risk on" in January.
The highest-return rating category in the asset class was the riskiest, namely CCC & Lower. The longest maturity basket, which is to say the riskiest, i.e., 15+ years, outperformed the overall index. Finally, by far the best-performing major industry was Energy, the riskiest by the volatility measure of standard deviation of monthly returns in the latest year.
Energy did not narrowly edge out the other 19 industries by this metric. Its standard deviation was 12.04%. The others were in the range of 1.70% to 6.99%. For all 20, the median volatility measure was 3.55%.
Shortest HY bonds performed best
The Treasury yield curve shifted upward in January, with increases ranging from 0 basis points on the two-year to 22 bps on the 30-year. Combined with an 18-bps steepening of the curve (two to 10 years), the message was that the economic outlook was improving as COVID-19 vaccination progressed. Treasury returns declined monotonically with each step out on the maturity scale. All but the two-year maturity finished the month in the red.
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MORE FRIDSON: Interest rate sensitivity, corporate vs preferred indices
CCC & Lower issues far outpaced BBs and Bs
Vindicating last month's short-term trading recommendation to overweight CCC & Lower bonds, the lowest-rated speculative-grade bonds walloped their higher-quality peers by racking up a 2.36% total return for the month. In fact, as the table below shows, the riskiest high-yield issues were the only category to record a positive price change in January. CCC & Lower was the worst-performing rating category in 2020 as a whole but far outpaced BBs and Bs in the last four months of the year.
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The top-performing rating category, CCC & Lower, had a smaller market-weight concentration than the ICE BofA US High Yield Index — 8.5% versus 13.5%. The bottom-tier Energy bonds, however, generated extraordinarily high returns in January. Energy accounted for 16 of the CCC & Lower category's 20 best performers, with total returns ranging from 17.39% to 35.06%.
Energy topped industry returns
For the third consecutive month, Energy ranked No. 1 in total return among the 20 largest high-yield industries (see table below). In the two months before that streak began, Energy finished No. 20 and No. 19. Wide performance swings throughout 2020 landed Energy in last place for the full year. January's league-leading 1.47% was propelled by a continuing rise in Energy prices. The Generic First Crude Oil, West Texas Intermediate futures jumped from $48.52 to $52.20.
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Leisure debuted in the top 20 industries with a last-place return in January's total return rankings. The industry pulled ahead of Building Materials in aggregate market value and thereby displaced it as the 20th largest industry within high-yield.
Newcomer Leisure has least favorable ratings outlook among 20 biggest industries
The credit outlook still has a long way to go to get back to neutral. Just three of the asset class's 20 largest industries by market value currently have net favorable ratings prospects, as indicated by positions to the right of zero on the chart below. At the opposite extreme, Leisure, which replaced Building Materials in the top 20 this month, has the most negative ratings prospects (-78.38% on the horizontal scale). The market is compensating investors for Leisure's downgrade risk, however, as indicated by its location above zero on the vertical scale. Furthermore, Leisure's location above the diagonal Fair Value line suggests overcompensation, as it indicates that the industry is cheap to its industry peers on a rating-for-rating basis.
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In one other noteworthy change from December, Super Retailing (department stores, discounters, and specialty stores) fell below zero on the vertical scale. The industry is now expensive, rather than cheap to its peers on a rating-for-rating basis. Super Retailing's relative value declined after it turned in January's second-highest return among major high-yield industries (see "Major industries ranked by total return" table, above).
The least attractive, southwestern quadrant (expensive despite negative ratings prospects) continues to contain such classically defensive industries as Consumer Products, Containers, and Food, Beverage & Tobacco. Investors willingly accept inferior rating-for-rating spreads on these industries, despite agency warnings that their ratings are likely to decline.
These conclusions are based on the methodology introduced in "New industry analysis shows defensives too tight." See the table below for each industry's coordinates. According to our analysis, industries located above (below) the diagonal regression line in the preceding chart are cheap (expensive) versus their peers, taking into account both their spreads, adjusted for ratings mix, and positive or negative biases in their ratings outlooks and watchlists.
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Neutral position on CCC & Lower issues now recommended for short-term traders
Short-term traders should switch from overweight to neutral on CCC & Lower issues. Our recommendation is based on the analysis presented in "When to over- or under-weight CCC & Lower issues." In January, the ICE BofAML CCC & Lower U.S. High Yield Index outperformed the ICE BofA BB-B U.S. High Yield Index for the third consecutive month after a period (the month of October) of producing an inferior return. Under such circumstances, our analysis has found no statistically significant tendency of CCC & Lower issues to repeat their outperformance in the following month.
Last month's switch from neutral to overweight on the CCC & Lower sector worked out favorably. As detailed above, lowest-rated issues returned 2.36% in January. That far outpaced BBs at 0.05% and Bs at 0.22%.
As always, we caution that this methodology is expected to deliver an edge over time rather than a win every single time that a nonneutral recommendation is generated. Note as well that at any particular time, the appropriate strategy for long-term, value-oriented investors may differ from the recommendation produced by this shorter-term, momentum-based approach.
Value investors should remain neutral on CCC & Lower issues
We are maintaining our neutral recommendation on the CCC & Lower sector for patient, value-oriented investors. As documented in "CCC & Lower relatively cheap in rich HY market," variance in the ICE BofA CCC & Lower U.S. High Yield Index's option-adjusted spread, or OAS, is mostly a function of the ICE BofAML BB-B U.S. High Yield Index's OAS. We calculate fair value for the CCC & Lower segment using the following regression formula, with spreads denominated in basis points:
2.34 x BB+B OAS + 73.44 = Fair value of CCC & Lower
In January, the BB+B OAS widened slightly to +334 bps, from +328 bps in December. Plugging the Jan. 31 BB+B OAS into our formula produces a fair value of +855 bps for the CCC & Lower index. By this measure, CCC & Lower issues were moderately tighter than their exact fair value on Jan. 31, with an actual OAS of +736 bps, down from +803 bps a month earlier. The minus 119 bps differential between fair value and actual spread compares with smaller disparity of -38 bps a month earlier but remains far away from our one-standard-deviation threshold of -254 bps for declaring an extreme overvaluation. Accordingly, we continue to recommend a neutral weighting for the CCC & Lower sector for longer-horizon, value-oriented investors.
US distressed should remain underweighted
As detailed in "How to tell when distressed bonds are attractive," the U.S. distress ratio, defined as the percentage of issues in the ICE BofAML U.S. High Yield Index quoted at distressed levels (OAS of 1,000 bps or more), can be used to derive the market's implicit forecast of the speculative-grade default rate. The distressed default rate — conceptually, the percentage of distressed issuers that default within one year — declines as the distress ratio increases. Multiplying the distress ratio by the distressed default rate gives us the market's expected 12-month default rate.
On Jan. 31, the distress ratio was 4.48%, down materially from an already low 5.52% one month earlier. The latest ratio is well below the 1997-2019 monthly mean of 13.82. Using the updated methodology described in "Estimating the market-implied default rate," we calculate an expected distressed default rate of 34.1%, indicating that the market is priced for a default rate of just 1.5% over the next 12 months. That compares with an implied Moody's forecast of 4.1%. We derive this estimate by multiplying Moody's U.S. bonds-plus-loans forecast of 6.0% by the 0.68 ratio of the agency's global bonds-only to global bonds-plus-loans forecasts.
At a gap of 1 percentage point or more, we conclude, based on historical analysis, that the distressed sector is likely to produce below-average returns over the coming 12 months. The present disparity of 2.6 percentage points far exceeds that threshold. Accordingly, we continue from last month our underweight recommendation for distressed debt within a high-yield portfolio.
Neutral weighting now recommended for high-yield versus investment grade
We are changing our previous underweight recommendation to neutral on high-yield in a portfolio that also contains investment-grade corporates.
At +281 bps, the option-adjusted spread differential between the ICE BofA US High Yield Index and the investment-grade ICE BofA US Corporate Index is above the threshold of +265 bps, below which we recommend underweighting high-yield. This conclusion is derived from the methodology introduced in "High-yield vs. investment-grade workout periods."
Underweighting still recommended on European distressed debt
As detailed in "European distressed debt fairly valued at present," the European distress ratio, defined as the percentage of issues in the ICE BofA Euro High Yield Index quoted at distressed levels (OAS of 1,000 bps or more), can be used to derive a leading indicator of the speculative-grade default rate. The distressed default rate — conceptually, the percentage of distressed issuers that default within one year — decreases as the distress ratio increases. Multiplying the distress ratio by the distressed default rate yields the market's expected 12-month default rate.
At the end of January, the European distress ratio was 3.41%, down from 3.97% one month earlier. Using the methodology described in the above-referenced Feb. 24, 2016, piece, we calculate an expected distressed default rate of 26.1%, indicating that the market is priced for a default rate of 0.9% over the next 12 months. That compares with an implied Moody's base-case forecast of 2.0%, down from 2.4% one month earlier. We derive this estimate by multiplying Moody's European bonds-plus-loans forecast of 3.0% by the 0.68 ratio of the agency's global bonds-only to its bonds-plus-loans forecasts. The market's forecast undershoots the inferred Moody's base case forecast by 1.1 percentage points. When the European market-implied default rate is 1 percentage point or more below the Moody's forecast, we infer from our U.S. research that the distressed sector is likely to produce below-average returns over the coming 12 months. Because the difference between the Moody's forecast and the market-implied forecast currently exceeds that cutoff, we are maintaining our previous underweight recommendation on European distressed debt.
Global high-yield investors should remain neutral on Europe
During January, the European Equalized Ratings Mix, or ERM, spread tightened by 1 basis point, while its U.S. counterpart widened by 3.3 bps. The differential between the two regions consequently increased to +20.8 bps, from +16.5 bps. That change moved the European high-yield from the moderately rich zone to the fairly valued zone versus the U.S.
We recommend underweighting Europe only when it is extremely rich versus the U.S. Accordingly, we are maintaining our neutral recommendation on Europe within a cross-border high-yield portfolio. Europe is fairly valued when the ratings-equalized OAS differential between the ICE BofA Euro Non-Financial Constrained Index and the ICE BofA U.S. Non-Financial Constrained Index is in the range of 20.1 to 48.1 bps.
Our current conclusion regarding valuation derives from the ERM methodology described in "Europe-versus-U.S. valuation." The 2013 report introduced a technique for addressing the analytical challenge that Europe's high-yield market is much more heavily concentrated than its U.S. counterpart in BB issues. A direct comparison of quality spreads between the two regions mainly demonstrates that Europe's high-yield universe is less risky. It does not tell us whether investors are compensated more generously or less generously for a given level of credit risk in Europe than in the U.S. To remedy this problem, we equalize for the vast difference in ratings mix between the two regions to determine which region is trading cheaper, rating for rating.
Neutral weighting still recommended for emerging markets HY
We are continuing our neutral recommendation on emerging markets high-yield debt within a portfolio that also includes U.S. high-yield debt. On an ERM basis, the ICE BofA U.S. Emerging Markets Corporate Plus Index's ERM-based OAS tightened by 10 bps in January. Over the same period, the ICE BofA U.S. High Yield Index's ERM-based OAS widened by one basis point. The ERM-basis EM-minus-U.S. high-yield spread consequently ended January at +167.5 bps, up from +158 bps in December. That change in ERM spread left the EM-minus-U.S. differential in the third quartile of historical spreads. Because the third quartile indicates fair EM valuation, we are maintaining our neutral recommendation on emerging market high-yield debt.
The backstory on this recommendation is provided in "High-yield relative value, emerging markets versus U.S." That report introduced an analysis of relative value for emerging market corporates and U.S. high-yield. The key to this methodology is adjusting for the substantial difference in ratings mix between the ICE BofA High Yield U.S. Emerging Markets Corporate Plus Index and the ICE BofA U.S. High Yield Index. After that adjustment, the emerging markets sector invariably has a wider OAS than U.S. high-yield, but the magnitude of the differential varies widely over time. In the equity market, similarly, emerging markets are perennially accorded lower multiples than the U.S., reflecting concerns about the rule of law and corporate governance.
Research assistance by Bach Ho and Ducheng Peng.
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