Corporate Credit Conditions: Part 3
As discussed in part two (prior installments linked below), the duration mismatch between LQD and HYG renders the ratio useless as a tool to assess credit distress or changes in investor preference. Credit ETFs, must be compared to a duration matched ETF, Treasury security or index to be useful.
There is also the difficulty in comparing spreads across investment cycles. For instance, credit quality across both investment grade (C0A0) and high yield (H0A0) indexes have changed significantly over the last three years. During the pandemic recession over 200 billion of investment grade (IG) debt was downgraded to high yield (HY). This improved the quality of IG, making it less susceptible to a downgrade cycle. Additionally, the debt refinancing wave of the last three years left record cash on IG balance sheets, sharply reducing their need to issue new debt into the higher rate environment. In fact, IG interest coverage is at a record high of 12.8 times. The combination should result in significantly less IG spread widening than in past recessions/downgrade cycles.
A way to monitor risk preferences is to utilize the arithmetic difference between HY and IG OAS. The idea is that as investor preferences swing between risk on and risk off, that the spread between the risk premiums will reflect this. If credit conditions are deteriorating, the spread will widen as investors demand a greater risk premium. When the Fed began tightening the spread was 226 basis points (bps). The initial surge peaked in June at +529 bps and has now narrowed to 339 bps, only 113 bps higher than the start of the year. Viewed in this manner, it is again hard to see why the Fed would be overly concerned.
To place this spread difference into historical context I again plot 1 and 2 standard deviation bands around the regression line. Its not surprising that with both IG and HY OAS at their historical mean (see parts one and two) that the spread would also be at its historical mean. Again there is little in the data that would suggest that the Fed should be alarmed with credit or suggesting that there is compelling investment value.
In the final part of this series we will examine the extremely high all-in-yields of IG bonds and use traditional technical methods to reach an opinion on BBB (the lowest rung of IG) credit.
And finally, many of the topics and techniques discussed in this post are part of the CMT Associations Chartered Market Technician’s curriculum.
Good Trading:
Stewart Taylor, CMT
Chartered Market Technician
Taylor Financial Communications
Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.
There is also the difficulty in comparing spreads across investment cycles. For instance, credit quality across both investment grade (C0A0) and high yield (H0A0) indexes have changed significantly over the last three years. During the pandemic recession over 200 billion of investment grade (IG) debt was downgraded to high yield (HY). This improved the quality of IG, making it less susceptible to a downgrade cycle. Additionally, the debt refinancing wave of the last three years left record cash on IG balance sheets, sharply reducing their need to issue new debt into the higher rate environment. In fact, IG interest coverage is at a record high of 12.8 times. The combination should result in significantly less IG spread widening than in past recessions/downgrade cycles.
A way to monitor risk preferences is to utilize the arithmetic difference between HY and IG OAS. The idea is that as investor preferences swing between risk on and risk off, that the spread between the risk premiums will reflect this. If credit conditions are deteriorating, the spread will widen as investors demand a greater risk premium. When the Fed began tightening the spread was 226 basis points (bps). The initial surge peaked in June at +529 bps and has now narrowed to 339 bps, only 113 bps higher than the start of the year. Viewed in this manner, it is again hard to see why the Fed would be overly concerned.
To place this spread difference into historical context I again plot 1 and 2 standard deviation bands around the regression line. Its not surprising that with both IG and HY OAS at their historical mean (see parts one and two) that the spread would also be at its historical mean. Again there is little in the data that would suggest that the Fed should be alarmed with credit or suggesting that there is compelling investment value.
In the final part of this series we will examine the extremely high all-in-yields of IG bonds and use traditional technical methods to reach an opinion on BBB (the lowest rung of IG) credit.
And finally, many of the topics and techniques discussed in this post are part of the CMT Associations Chartered Market Technician’s curriculum.
Good Trading:
Stewart Taylor, CMT
Chartered Market Technician
Taylor Financial Communications
Shared content and posted charts are intended to be used for informational and educational purposes only. The CMT Association does not offer, and this information shall not be understood or construed as, financial advice or investment recommendations. The information provided is not a substitute for advice from an investment professional. The CMT Association does not accept liability for any financial loss or damage our audience may incur.
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