An analogy we have often used for the relationship between equities and high yield credit is light versus full strength beer. Stated differently, junk bonds have around half the volatility of equities with common underlying drivers. Most important is the profit cycle as debt is ultimately repaid out of cash flow. That is the key fundamental reason why the junk bond index looks like a low beta version of the S&P500 (chart 1).
Of course, we would note that the distribution of returns on high yield is not normal. Rather, high yield exhibits a “fat-tailed” distribution or a higher probability of an extreme outcome. After one of the worst years on record for credit, some market participants have turned bullish. However, from our perch, the credit risk premium is probably insufficient for the probable hard landing in corporate earnings.
While there has clearly been a material widening in the high yield spread this year, it is notable that US junk bond spreads remain below the long-term average (around 500 basis points). To be fair, the concurrent increase in risk free rates has contributed to a material 11% decline in the total return index on the high yield market (approximately 60% of the drawdown in the S&P500). Credit spreads are ultimately a measure of risk perceptions or the market’s judgment on default risk. In turn, that tends to have a reflexive or self-reinforcing relationship with the earnings or cash flow cycle.
The forward-looking point is that the current credit risk premium is probably insufficient for the probable contraction in earnings. As we have noted recently, the decline in manufacturing surveys (inverted in the time series below so that a fall in the purchasing manager surveys is correlated with a widening in credit spreads) suggests that the high yield index spread probably should be around 300-400 basis points wider than current levels (chart 2).
That observation is also consistent with consumer sentiment, housing market and small business confidence as well. Those measures of confidence and future activity have deteriorated in response to the increase in policy rates and tightening in broader financial conditions. The magnitude of the tightening in financial conditions this year is also probably consistent with US and EU high yield spreads closer to 900 to 1000 basis points, or default rates around 6%. We would note that the Asian High Yield Index is already trading around 1500 basis points or at distressed levels (a rule of thumb for distressed credit is a spread over 1000 basis points).
Like equities, the bullish scenario is that risk free rates ease, and the economy avoids a hard landing. While that is plausible, our sense is that the odds are not great. However, if US and European spreads do widen towards 1000 basis points in the first half of 2023, that is probably an attractive entry point to scale into high yield bonds. The best returns in credit have historically been achieved from the most uncomfortable point in the credit cycle. Although investment grade spreads also under-price credit risk, they would more likely benefit from long duration or a fall in Treasury yields as the government bond market starts to price a hard landing or recession. Within the credit universe we prefer EM/Asian high yield as that is already priced for distress.
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