Derivative longs versus cash corporate shorts looks attractive, especially if we see a market sell-off

Kelley Baum

Head of credit derivatives

III Capital Management/AVM

Technicals are keeping cash credit spreads tight, but as central banks reduce purchases there will be relative value opportunities

In the first quarter of 2022, as the US investment grade corporate market was driven by a near 100 basis point sell-off in 10-year rates, it posted -7.9% — the worst quarterly total return in recent history. With rising inflation and the expectation of continued rate hikes, further interest rate sell-offs could follow. However, cash corporate spreads have remained tight, especially when compared to derivative spreads — a dynamic that is persisting across markets in the US and Europe (in IG and HY).

Strong fundamentals have contributed to persistent demand for corporate cash. After the initial wave of covid crisis-related defaults in 2020, default rates fell in 2021 to close to 1% in US high yield, and default projections remain at 1-1.5% through the end of 2023. Leverage has also continued to improve, with US investment grade leverage falling from over 2x in mid-2020 to roughly 1.7x, European investment grade falling from over 2x to under 1.5x, and US high yield leverage decreasing from over 4x to just under 3x.

Corporate issuance in 2020-21 pushed out near-term maturities, especially in US HY, improving the fundamental refinancing runway of many corporates and decreasing the need for overall near-term issuance. In US HY, average ratings have been increasing, with more than 50% of the universe now rated double B, compared to roughly 40% a decade ago. In contrast, US IG quality has worsened, with triple Bs making up over 50% of the universe now versus about 40% 10 years ago, and average durations now at elevated levels.

Technicals are keeping cash tight

In European IG, the ECB increased the pace of its corporate sector purchase programme in Q1 to an eight-week cumulative gross run rate of roughly €16 billion, versus a run rate of €11 billion in Q3-Q4 2021. The ECB owns almost 30% of the eligible universe of credits. Even though it will likely stop purchases later this year, its demand seems to be overwhelming any expectations of a future slowdown.

In US HY, net supply turned negative in the first quarter, in part due to issuers seeking to wait out rate volatility and a lack of pressing near-term maturities. Combined with steady US HY fundamentals and higher yields, end-user demand has remained strong, and this has contributed to what we see as the biggest dislocation between cash and derivative markets. In US IG, higher yields have also attracted yield-based buyers that have demanded longer-dated credit.

The question remains, will these technicals persist in the months to come? In European IG, the ECB buying technical seems the most obvious one to call for a reversal — the ECB is the major marginal buyer, and it has indicated it will step away. In US HY, issuance may increase somewhat if interest rate volatility moderates, but the major maturity wall remains in the three-to-five year range, so issuance could remain low.

It may take more significant growth concerns to impact credit fundamentals and lead to lower demand in US HY credit. In US IG, the technical backdrop remains murkier as the scope of demand from overseas investors, who have recently been the marginal buyer, is hard to gauge (from the seat of a hedge fund trader, at least). But dispersion may increase as high inflation impacts different sectors in different ways.

Beyond the fundamentals we know and the technicals we can attempt to predict, the backdrop remains that in major market sell-offs (ie, March 2020 and 2008-09), cash corporates have historically underperformed derivatives by a significant margin. In a relative value sense, derivative longs versus cash corporate shorts looks attractive, especially as this strategy could outperform if we see another major market sell-off.

Historically, investors have needed to sell cash corporates as funding became stressed and in order to meet margin calls across broad portfolios. So while the near-term moves may be impossible to predict, the current entry points, potential technicals and risk-reward in a crisis all seem slated to favour this approach.

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Global credit funds & CLO's

May 2022 | Issue 245

Published in London & New York.