Synopsis: The high-yield universe’s extreme overvaluation has ended, but only because spreads have widened dramatically on troubled Energy and Metals & Mining bonds. Record-low covenant quality in July was an optical illusion arising from a drop-off in Caa issuance.

With the help of a sharp sell-off in early August and some reduction in the Fair Value spread, the high-yield market has exited the extreme overvaluation zone. The significance of that change depends, however, on whether one is a direct investment manager or an end investor, e.g., a plan sponsor, endowment fund, or mutual fund shareholder. Since the end of June commodities-related issues have widened dramatically, but in aggregate the spreads on other issues remain unduly tight.

Gap versus fair value shrinks

By way of background, our valuation conclusions are based on econometric modeling methodology described in “Determining fair value for the high-yield market” (Nov. 13, 2012). (This report is now also available at highyieldbond.com.) In brief, we find that 82% of the historical variance in the option-adjusted spread (OAS) of the BofA Merrill Lynch US High Yield Index is explained by five variables:

• Credit availability, derived from the Federal Reserve’s quarterly survey of senior loan officers
• Capacity utilization
• Industrial production
• Current speculative-grade default rate
• Five-year Treasury yield

Historically, when the overall risk of the market, as measured by these five variables, has been at its present level, the index’s OAS has averaged exactly 600 bps. The actual Aug. 31 spread was 536 bps, a difference of –64 bps. That shortfall was less than half as great as the –130 bps difference (equivalent to one standard deviation) that we characterize as an extreme. By Aug. 14, the actual OAS had widened to 552 bps, reducing the gap versus fair value to –48 bps.

In contrast to these comparatively mild overvaluations, the Fair Value spread on June 30 was 630 bps versus an actual OAS of 500 bps, a difference of 130 bps that just qualified as an extreme. In the intervening month, Credit Availability improved slightly and Industrial Production rose from +0.1% to +0.6%. The five-year Treasury yield, which is inversely correlated with the spread, dropped from 1.63% to 1.54%. Neither Capacity Utilization nor the Current Speculative-Grade Default Rate changed materially. The chart below depicts the historical relationship between the actual spread and Fair Value.

Energy and Metals & Mining versus the rest of the universe

Officially, the spread on the BofAML High Yield Index increased from 500 bps on June 30 to 552 bps on Aug. 14. Half of that 52 bps increase was attributable, however, to just two industry subindexes – the BofA Merrill Lynch US High Yield Energy Index and the BofA Merrill Lynch US High Yield Metals & Mining Index. The former widened from 712 to 922 bps and the latter from 979 to 1,219 bps. Using the weighted-average method, we find that the remainder of the BofAML High Yield Index widened by just 26 bps, from 443 to 469 bps (see note 1).

For a speculator contemplating the purchase of a high-yield mutual fund, the widening to 552 and associated elimination of extreme overvaluation are highly pertinent. True, a fund with a market weighting in Energy and Metals & Mining contains a lot of risk. If commodity prices temporarily stabilize and the market rallies, however, the mutual fund shareholder will benefit on the basis of beta.

The situation is different for a portfolio manager who is trying to beat the high-yield benchmark. At an OAS of 469, the 84% of the high-yield universe not accounted for by Energy or Metals & Mining remains extremely overvalued, at –131 bps versus fair value. The “reasonable” prices on high-yield bonds are largely a function of very wide spreads on commodities-related issues that the PM is probably hesitant to add to at this point. With the rest of the index still quite rich, generating alpha through issue selection represents a tough challenge.

July’s record-low covenant quality was an optical illusion

Moody’s reported a high-yield covenant quality score of 4.60 in July. As explained in “Covenant quality decline reexamined” (Oct. 1, 2013), Moody’s rates each covenant of essentially every U.S. high-yield new issue on a scale of 1 (strongest) to 5 (weakest). The agency weights those scores to assign an overall covenant quality score to the issue. Moody’s then compiles the issue ratings to calculate a market-wide covenant quality (CQ) index. In the chart below the dashed line indicates that July’s covenant quality was the weakest since the inception of the series in January 2011.

The solid line traces FridsonVision’s version of the covenant quality series. We modify the Moody’s CQ Index to remove noise arising from month-to-month changes in the calendar’s ratings mix. On average, covenants are stronger on triple-Cs than on single-Bs and stronger on single-Bs than on double-Bs. Therefore, as an example, if issuance shifts downward in rating in a given month without covenant quality changing within any of the rating categories, the Moody’s CQ Index will show a spurious improvement. We eliminate such false signals by holding the ratings mix constant at an average calculated over a historical observation period.

June’s ratings mix was close to the historical average of roughly one-quarter each in Ba and Caa and one-half in B. In order, from top to bottom, the weights were Ba 24%, B 48%, and Caa 28%. During July, however, quality shifted radically upward, to Ba 56%, B 25%, and Caa 19%. It is not unusual for new issue quality to improve during negative-return months such as July, as those conditions make it unattractive for the lowest-rated credits to come to market.

Because credit quality is inversely correlated with covenant strength, the June-to-July shift in ratings mix created the appearance that covenant quality in general deteriorated, based on the move from 4.55 in June to 4.60 in July. On a rating-for-rating basis, however, our calculations show that covenant quality improved from 4.56 to 4.38. This was one of the most dramatic divergences ever between the raw data and the refined analysis that filters out the effect of monthly variance in ratings mix.

Marty Fridson, Chief Investment Officer of Lehmann Livian Fridson Advisors LLC, is a contributing analyst to S&P Capital IQ. His weekly leveraged finance commentary appears exclusively on S&P Capital IQ LCD. Marty can be reached at marty@fridson.com.

Research assistance by Yueying Tang and Zizhen Wang.

Notes

The BofAML High Yield Energy Index accounted for 17.79% of the BofAML High Yield Index’s market value on June 30 and 16.35% on Aug. 14. For the BofAML High Yield Metals & Mining Index, the comparable figures were 3.36% and 2.99%. As the prices of their bonds decline, these two industries exert less and less impact on the overall index’s spread. Their impact may also be reduced by defaults, which reduce the face value of the industry subindexes in which they occur. Moreover, a default by a bond previously quoted at an extremely wide spread will cause the relevant subindex’s spread to tighten as that issue exits.

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