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.
Overvaluation of the U.S. high-yield bond market, based on the factors that ordinarily drive its risk premium, would literally be off the chart these days, but for one thing. The cutoff on the vertical axis goes beyond –500 bps, representing the difference between month-end option-adjusted spread, or OAS, on the ICE BofA US High Yield Index and our Fair Value estimate (methodology below).
As long as the Federal Reserve continues to intervene in the credit markets on a scale never previously contemplated, it is pointless to discuss high-yield valuation in any sort of historical context.
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Our Fair Value estimate for the index's spread increased by 67 bps in May, to +1,331 bps, from +1,264 bps in April.
Meanwhile, the actual OAS narrowed to +654 bps from +763 bps. The May 31 gap of –610 bps between the actual spread and Fair Value widened even as the actual spread tightened to +602 bps on June 19. The significance of these numbers lies mainly in dramatizing the extent to which the Federal Reserve's extraordinary support of the credit market is shifting speculative-grade yields.
For the record, May's reduction in our Fair Value spread reflected improvements in capacity utilization, to 64.8%, from 64.0%, and industrial production, to +1.4% from –12.5%. Somewhat offsetting those effects was a decline in the five-year Treasury yield, which is inversely correlated with the spread, to 0.31% from 0.35%. The default rate edged up to 4.6%, from 3.9%, but that is a backward-looking indicator that has little impact on the spread.
Our credit availability measure, reported only once a quarter by the Federal Reserve Board, was unchanged at 41.6%. That historically huge excess of banks that are tightening credit standards over those that are easing credit standards accounts in large part for the historically wide Fair Value spread. Also unchanged was our dummy variable for quantitative easing. At 1 (rather than 0), this factor substantially reduces the Fair Value spread, all else being equal.
These conclusions are drawn from the updated methodology presented in “Fair Value update and methodology review” (LCD News, Jan. 24, 2018). In brief, we find that 80% of the historical variance in the ICE BofAML US High Yield Index's OAS is explained by six 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; and
- A dummy variable for the period covered by quantitative easing.
Each month we calculate a Fair Value spread based on the levels of these six variables. The extent of high-yield overvaluation or undervaluation is determined by the difference between the actual OAS and the Fair Value number (“estimated”). We define an extreme valuation as a divergence of one standard deviation (124.5 bps) or more from Fair Value. The monthly difference between the actual and estimated OAS is tracked in the chart above.
Covenant quality got worse, not better in May
Correcting for the impact of a downward shift in the ratings mix from April, high-yield covenant quality in the U.S. speculative-grade segment declined a touch in May.
On the scale employed by Moody’s (1 = strongest, 5 = weakest), FridsonVision's series deteriorated to 4.46, from 4.41 in April. Moody's own series, by contrast, showed a slight improvement, to 4.51 from 4.55. As the chart below shows, the two versions of the covenant quality series are not currently far apart (both May scores round off to 4.5), yet it is worthwhile explaining the reason for the latest month's divergence in direction.
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Consistent with the general pattern over time, May's average scores for rating categories were worst for Ba issues (4.64) and best for Caa issues (4.26). The ratings mix worsened in May as the Ba share dropped to 50.0%, versus 70.2% in April, while the Caa share rose to 10.4%, from zero percent. That shift toward a category with stronger covenant quality scores caused the Moody's series to show an improvement, even though the B score worsened significantly to 4.41%, from 4.28%, while the Ba and Caa scores were nearly unchanged (moving to 4.64, from 4.67 for Ba and to 4.26, from 4.24 for Caa).
As detailed below, the FridsonVision methodology eliminates anomalies such as May's Moody’s-method improvement by filtering out the effects of month-to-month fluctuations in the ratings mix.
By way of background, “Covenant quality decline reexamined” (LCD News, Oct. 1, 2013) explains how 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 Caa bonds than on Bs, and stronger on Bs than on Ba bonds. Therefore, for example, if issuance shifts downward in ratings mix 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. (To be fair, Moody’s acknowledges the impact of ratings mix in its monthly commentary on its CQ Index.)
Research assistance by Lu Jiang and Zhiyuan Mei.
ICE BofA Index System data is used by permission. Copyright © 2020 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann, Livian, Fridson Advisors, LLC’s use of such information. The information is provided "as is" and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.
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