High Yield in the Far East

June 17th, 2020

From our perch, the Fed could not have been more clear on their support for the credit markets in the form of both unlimited or open ended QE and in terms of purchases of corporate bonds via ETFs. The Fed further reinforced that commitment overnight with the promise to purchase individual corporate bonds directly in the secondary market. The Fed’s announcement has been followed by additional fiscal policy support from the US and Japan today during Asian hours which has contributed to the turn around in risk asset performance (+6% from the low in the S&P500 futures on Monday). While we were somewhat cautious on risk compensation in the first week of June following the rally, it is hard to be too bearish on risk assets when the team printing the money is also buying them. The forward looking question is this: where is credit risk premia and expected returns most attractive?

Since the trough in late March and again on April 9 the Fed Chair has been very clear about the unlimited support for the credit markets and that has clearly been reflected in both corporate bond issuance and credit spreads. High yield spreads have narrowed by more than 500 basis points from the wide in March and US investment grade spreads have compressed back into the long term (20-year) average of around 150 basis points (on the Bloomberg Barclays index – chart 1).

As we have often noted in the past, there is an intimate link between liquidity, volatility and leverage (chart 1 above). The first phase of this crisis contributed to a large correlated decline in risk assets with forced de-leveraging. As dollar liquidity tightened and equity prices declined that led to a spike in equity volatility, followed by a self-reinforced widening in credit spreads. The initial phase was clearly and successfully reversed with the Fed’s commitments noted above. The Fed’s support was also in the form of providing dollar liquidity to foreign central banks in the form of swap lines. In turn that reversed US dollar strength during the forced de-leveraging phase and also likely contributed to the credit spread compression in global credit markets (chart 2).

The direct answer to the question above is that macro credit risk premia appears most attractive in Asian High Yield. While there are some specific issues with Asian high yield. For example, escalating tension between the United States and China, in addition to the increase in China high yield property net supply (which is a material component of the index) spreads are; 1) more than 215 basis points wider than US high yield (chart 3); 2) around 250 basis points above the historic average Asian high yield spread; and 3) exposed to the strong cyclical rebound in Asian economies next year. Historically, during bullish phases it is possible for Asian high yield to trade at a tighter spread than the equivalent US high yield.

In conclusion, the Fed’s additional or reinforced commitment to support the corporate credit markets is bullish for US high yield and equities (as the asset class at the bottom of the capital structure). However, from a macro perspective, credit risk compensation is more attractive in Asian high yield. Historically, the Fed has also had an important influence on credit spreads in global markets given the central role of the dollar as the reserve currency. While the escalation in tension between the US and China is a non-trivial risk for Asian markets, that is probably trumped by Fed liquidity. Moreover, 8.2% carry is attractive in a zero rate world.

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