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.

Last week, market commentators vied to explain a sharp drop in Treasury rates. From 1.48% on July 1, 2021, the ICE BofA US 10-Year Treasury Index's yield fell day by day to 1.29% on July 8 before rising to 1.36% on July 9. The 19-basis-point peak-to-trough decline in less than a week contrasted with a narrow 9 bps trading range during essentially the two preceding weeks (June 16 to June 30).

Our survey of commentaries on the sudden interest rate decline found pundits offering a variety of explanations:

* Perception that U.S. economic growth has peaked for this cycle. Peak fiscal stimulus is past and prospects for major new spending on infrastructure and family support have dimmed. In addition, persistent supply chain problems are constraining GDP gains.

* Anticipation of an eventual Fed cutback on bond purchases.

* Declines in long-term rates in other countries. This possibly reflects anxiety about the COVID-19 delta variant and slow progress in vaccinations. In addition, U.S. vaccine hesitancy is cited as a weakness in the reopening story.

* Technical factors: Reduced Treasury issuance due to the Treasury drawing down its General Account at the Federal Reserve more quickly than expected, plus short-covering by traders holding losing positions.

Naturally, interpretations involving a slowdown in economic growth and, by inference, in corporate earnings are anathema to equity market permabulls. Always eager to encourage inflows to their funds, they invariably have a positive spin on the fact, as well as ample resources to influence investors' perceptions. Predictably, our survey of recent market commentary surfaced a reference to money waiting on the sidelines to buy stocks.

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At the opposite pole are financial media outlets that follow the journalism rule, "If it bleeds it leads." Apocalyptic headlines draw more clicks than those along the lines of "Traders expect continued stability." Linking lower interest rates to a worsening economic picture and therefore a looming stock market calamity is guaranteed to capture eyeballs.

Might a market-based analysis, utilizing high-yield bond spreads, provide objective insight into the meaning of the early July Treasury rate drop?

The message from high-yield risk premiums

At first blush, the high-yield risk premium movement from July 1 to July 8 supports the thesis that the 10-year Treasury yield's decline over the same period reflected mounting concerns about the economic outlook. The option-adjusted spread, or OAS, on the ICE BofA US High Yield Index widened by 12 bps over the period. This suggests that worries about credit risk increased.

However, note that an increase in the spread in conjunction with a decrease in the Treasury yield is the predominant pattern. For example, over the period 2001-2020, the month-over-month change in the high-yield OAS had the opposite sign of the change in the Treasury yield 65.5% of the time. (That ratio, by the way, is statistically different from a 50/50 split with greater than 99.9% confidence.)

Bs and CCC-Cs widened by 15 bps and 14 bps, respectively, somewhat more than BBs' 9-bps widening between July 1 and July 8. Some differentiation in spread-widening by risk level is likewise the normal pattern. On the whole, the high-yield market is not sending a signal that the economic stumbling blocks enumerated presage a material escalation in default risk.

However, there was some migration toward more defensive industries between July 1 and July 8. That interpretation does not perfectly explain the spread change on all 20 major high-yield industries displayed in the table below (see note 1). In some cases, they may be affected by company-specific developments unrelated to general economic trends. Still, a pattern that involves economic sensitivity emerges when we compare the industries that widened by more and by less than the ICE BofA US High Yield Index's 12 bps.

Among the nine greater-than-index wideners, Aerospace and Automotive & Auto Parts qualify as cyclical manufacturers. Broadcasting and Super Retail (department stores, discounters, and specialty retailers) are sensitive to advertising expenditures and consumer spending, respectively. Leisure is a reopening play. Energy and Metals & Mining are disadvantaged by reduced expectations for commodity price appreciation. Food, Beverage & Tobacco is considered noncyclical but widened by just 1 basis point more than the index. (Gaming precisely matches the index's widening.)

No classically cyclical manufacturers are found among the 10 industries that widened by less than the index. Technology tends to be viewed as less sensitive to the ups and downs of the economy than traditional metal benders. Demand for the Containers industry likewise tends to hold up comparatively well during business slumps. Chemicals are tied to the business cycle, yet currently trade a bit tight, rating for rating, versus their industry peers. (See the industry relative value discussion below.) Tighter-than-peer-group spreads are a characteristic of industries such as Consumer Products and Cable & Satellite TV, which are widely regarded as resistant to recession and also widened less than the high-yield index from July 1 to July 8. The Utility industry is also commonly classified as defensive.

Falling interest rates represent good news for Homebuilders & Real Estate, as a drop in mortgage rates should help sustain the current boom in housing demand. Diversified Financial Services benefited in relative terms from the recent interest rate drop, just as it outperformed the ICE BofA US High Yield Index in price terms as rates fell in the second quarter, after underperforming it when rates rose in the first quarter. Rounding out the list of industries that widened less than the index were Telecommunications and Services. Both outperformed the ICE BofA US High Yield Index during the worst quarter of the COVID-19 pandemic (the first quarter of 2020), so investors may regard them as relatively safe havens in the event of economic stress.

Conclusion

Viewed at the industry level, changes in high-yield risk premiums from July 1 to July 8 suggest that market technicals alone do not explain why Treasury rates declined over that interval. Speculative-grade investors displayed a preference for noncyclicals during the period, supporting the view that the interest rate drop signaled at least a deceleration in the U.S. economy's rebound from last year's business downturn. Further upholding that interpretation are greater-than-index increases in risk premiums on commodity producers.

June's relative value update shows increased value in Utility industry

Our June 30, 2021, piece, Valuing high-yield industries in 3D – the volatility factor, made the point that some of the industry misvaluations indicated by our two-dimensional valuation model (rating-for-rating spread comparison and net ratings prospects) could be explained by adding historical return volatility to the analysis. A key conclusion was that even after making that adjustment, the Utility industry appeared to be significantly undervalued. As previously reported the ICE BofA US High Yield Utility Index's option-adjusted spread was 20.79% wide versus its peers on a rating-for-rating basis on May 31, even taking into account its highly negative net ratings prospects. That relative cheapness was not justified by high volatility; the Utility's historical standard deviation of total return was below the median of the 20 major industries covered by our model.

The Utility industry stands out again this month (see updated chart below), but for a different reason. It experienced the group's biggest month-over-month move on the graph's vertical axis, going from 20.79% cheap, rating for rating, to 36.77% cheap. By our analysis, high-yield Utility bonds are now the cheapest industry relative to their peer group, edging out even the longtime holder of that title, Energy. As we reported in the June 30 piece, Energy, unlike Utility, deserves to be as wide as it is versus its peers on a rating-for-rating basis, taking historical return volatility into account.

Utility's dramatic repositioning during June is attributable to spread-widening of 174 bps to 713 bps on five Talen Energy issues. Moody's downgraded the company's rating outlook from stable to negative and lowered its speculative-grade liquidity rating from SGL-2 to SGL-3. The agency cited medium-term financial pressure following the clearing of the May 2021 capacity auction at a lower-than-expected level.

In other notable changes from May's Industry Relative Valuation graph, Automotive & Auto Parts, Broadcasting, Gaming, and Leisure all moved from positive to negative on the vertical axis, i.e, from cheap to rich versus their industry peers on a rating-for-rating basis. Services made the opposite move, going from below to above the zero-percent line. On the horizontal scale, Diversified Financial Services and Super Retail (department stores, specialty retailers, and discounters) both moved from negative to positive net ratings prospects. Consumer Products went from modestly positive to perfectly neutral net ratings prospects.

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 watchlistings.

Leveraged loans recommendation goes to overweight

The fever line in the following chart now stands at 1.12 on the vertical scale. That puts it above the 1-standard-deviation threshold that triggers a recommendation to overweight loans them within a combined bond-loan portfolio. We are revising our recommendation accordingly.

Details of our relative valuation methodology for the two categories of debt appeared in Loans vs. bonds – Determining relative value. In brief, we compare the three-year discounted spread on the S&P/LSTA Leveraged Loan Index and the option-adjusted spread on the ICE BofA U.S. High Yield Index, after first adjusting for differences in ratings mix between the two asset classes. We convert the difference in these spreads into an index geared to one standard deviation from the mean in either direction. A reading of plus 1.0 indicates that bonds are extremely rich versus loans, and a reading of negative 1.0 indicates that loans are extremely rich versus bonds. Inside those bands, we recommend neutral weightings of loans and bonds.

Research assistance by Manuj Parekh and Weiyi Yang.

ICE BofA Index System data is used by permission. Copyright © 2021 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.

Notes

1. We also examined OAS changes on 15 smaller high-yield industries. Statistical noise arising from small numbers of issues rendered these results useless for our analysis. For similar reasons, our Industry Relative Value analysis has always focused on industries with the largest shares of the ICE BofA US High Yield Index's total market value.