There are concerns about volatile sectors in high yield, but IG may be vulnerable to macro changes

Kelley Baum

Head of credit derivatives III Capital Management/AVM

High yield has heavier exposure to energy and travel credits, but IG has more rate duration

As summer nears its end, credit spreads are close to cycle tights and implied volatility is close to cycle lows. Low volatility environments, especially if we are on the cusp of change, can be the perfect time to make broad portfolio adjustments.

Markets have seen small bouts of volatility over the past few months that may indicate a change is on the horizon. With rumblings in energy markets, looming central bank policy changes and increasing regional geopolitical stress, there are ample potential catalysts for a broad market correction.

The economic growth and inflation outlooks have moderated recently, in part due to increasing infection rates from the covid-19 delta variant. Growth concerns have been reinforced by supply chain disruptions, rising input costs, softer US consumer confidence, and Chinese policy tightening.

These factors have weighed on energy and travel credits, and have caused dispersion to rise off the low levels seen over the past few months. Energy names in the on-the-run HY CDX index, like Talen Energy, Nabors and Transocean, have widened by 60-90% of spread since the end of June, while the HY index spread is only 7% wider.

Tranche markets are pricing in higher dispersion, with equity tranches underperforming and implied correlations falling. And with energy and travel more heavily represented in HY, which is broadly more sensitive to changes in economic growth, a growth shock could weigh more on HY than IG.

The case for high yield

However, HY spreads are wide relative to IG (the ratio in CDX is currently around 5.9 versus a 10-year average of roughly 5.5), and the HY index quality is higher than normal due to many distressed names falling out of the index when they defaulted last year. In comparison, the IG index is now more concentrated in triple Bs.

With this backdrop, a growth shock may affect IG spreads more than HY. IG cash spreads, when adjusted for duration and quality, are at the tights over at least the past 25 years, whereas HY cash spreads are at more of an average level for cycle tights. Central bank policies have created intense demand for IG cash and are pushing cash spreads significantly tighter than CDS spreads in many cases.

Issuance also plays a role in credit relative value. This year, HY supply is at record levels as low defaults and distress have created a strong appetite for HY new issue. Consensus projections estimate strong supply over the next month, though fund inflows and higher fund cash balances may make this supply easy to absorb.

IG supply is also relatively high, but not at the record levels we’ve seen from HY. A burst of cash supply can affect derivative index spreads as they are often used as a cash placeholder, and derivative index long positions are frequently rotated into new issue cash credit.

Central bank outlook makes a difference

Though Federal Open Market Committee members present divergent views, many in the market believe the Fed may taper in November. However, a sooner-than-expected taper could awaken credit markets from their recent stupor, as a rate shock amid higher levels of issuance and leverage would put pressure on corporate fundamentals.

IG has more rate duration than HY — approximately 8.4 in IG vs 4.1 in HY (using Bank of America’s US corporate indices, C0A0 and H0A0). A rate shock may disproportionately impact IG over HY, with IG’s historically high leverage.

Currently, non-dealer positioning in IG is close to the average of the past year (the net long is $65.4 billion, with a 1-year z-score of -0.2), while HY is on the shorter-risk end of the range (still net long risk $10.0 billion, but with a 1-year z-score of 1.6*). With net positioning in HY already relatively short risk, technicals seem favourable for HY.

These factors — growth, issuance, central bank outlook, positioning technical — present a mixed outlook for IG and HY, but as they evolve they should help frame an understanding of relative value going forward. While there are concerns about volatile sectors in HY, it appears that IG — especially in cash markets — may be more vulnerable to macro changes, as it is priced to perfection.

* Source: DTCC

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Global credit funds & CLO's

September 2021 | Issue 238

Published in London & New York.