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Corporate Credit Conditions: Part 3As 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.
Editors' picks
FRED:BAMLH0A0HYM2
by CMT_Association
3
GDP is Bad and You Should Feel BadThe GDP number of 2.7% growth is being propped up by net exports, while consumption is at a cycle low. This is horrible for earnings expectations and risk assets. Net exports were at a low in prior quarters, making the economy look worse off than it was. Now the economy is actually worse off than it is and the metric is instead making it look better. This is why the NBER doesn't use "two quarters of negative GDP" to date recessions. There are too many false signals. Don't fall for the GDP meme. The pain is coming.
FRED:GDPC1Short
by coinhoIio
Credit Conditions and the Fed: Part 2In part 2 I take a quick look at high yield corporates and describe a common mistake made in using ETF ratios to monitor changes in credit risk. Part one and an earlier piece that described how to use the TradingView platform to monitor secondary market credit spreads are linked below. If there is any one thing that will produce a Fed policy a pivot, it is credit distress. Credit is far more vital to economic functionality than equity. If companies are unable to secure funding, they may face liquidity issues, and if liquidity problems become widespread, they have the potential to become systemic. In 2008 and again in 2020 credit markets were frozen. Particularly in 2008, many companies ran into barriers that inhibited their conducting their ongoing daily business lines. There were plenty of offers but, as I so painfully remember, in many cases zero bids…. None…at any price. It was this credit distress that convinced the Fed to move. In part 1 we looked at the weekly chart of the option adjusted spread (OAS) of the broad ICE BofA Corporate Index and concluded that the there is no evidence of the kind of credit distress that would galvanize the Fed, and that, at least on this basis, that there was no compelling value (rich/cheap) argument to be made. What of high yield? Does high yield OAS suggest a meaningful deterioration in credit markets? Again, I plot a regression mean and one and two standard deviation bands above and below. Just as in the IG market, high yield OAS has widened, but only to its long term mean, and this following a lengthy period of being nearly a standard deviation rich. In short, while spreads have widened somewhat, there is no compelling rich/cheap argument and certainly nothing that would suggest to the Fed that credit conditions are meaningfully impaired. I frequently see commentaries that use price changes in the high yield ETF (HYG) and the investment grade ETF (LQD) as a measure of investor risk preference. Since the January high, LQD is down 26.15% versus 19.65% for high yield. At first glance it appears as if investors prefer the lower quality HYG. But the price changes do not account for the differences in fund duration. Put simply, LQD at 8.36 years duration has roughly twice the interest sensitivity of HYG at 4.06 years. In other words, a 100 bps change in rate, will change LQD 8.36% and HYG 4.06%. LQD in Ratio with HYG and Ten Year Futures in Ratio to Five Year Futures: I also see analysis that uses the ratio between LQD and HYG to ascertain risk preference. But the direction of the ratio is almost completely due to the difference in duration. You can see this by compare LQD/HYG to the ratio between ten year and five year note futures. LQD/HYG ratio is almost entirely correlated with changes between five and ten year treasuries. When rates are volatile and directional the total return of many rate products generally a reflection of rates than it is investor quality preference. 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.
Editors' picks
FRED:BAMLH0A0HYM2
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Unemployment Rate vs SPXI'm just the messenger. SPX - orange Unemployment Rate - Blue Indicator - Moving Average out of Unemployment Rate This isn't a rule, as many sectors influence the market, but big crashes have been paired with a growing Unemployment rate. Here we can see that it bottomed and is consolidating - which proofs a strong economy and no need to crash - this suggests the ongoing decline was just a correction. To visualize this a bit more - I have coded a simple moving average to see when that curve will start heading up - and for now it isn't even turning up - this allows the market to push up before it starts turning. But when it will ... Hold on to your seats lads and ladies. It's gonna be a fast ride. Cheers!
FRED:UNRATE
by TheSecretsOfTrading
Corporate Credit Conditions Part 1Since credit has far greater potential to create systemic issues than does equity, corporate credit conditions are much more important to the Federal Reserve (Fed) than changes in equity prices. If you have interest in macro, monitoring and understanding the basics of corporate credit is a must have skill. If there is any one thing that might actually cause a Fed pivot, it is disfunction in this market. There is a significant amount of current commentary around the sharply higher all-in-yields of high yield (HY) and investment grade (IG) corporate debt. In most cases the pieces conflate extreme price weakness in the large credit ETFs (HYG & LQD) with credit distress. Most pieces seem to conclude that the declines are linked to declines in credit quality and highlight financing problems in the sector. Most of that commentary suffers from a misunderstanding of the relationship between credit and Treasury spreads, what the price declines/yield increases are communicating about macro conditions, and how vulnerable companies, particularly IG companies, are being forced to refinance into a higher rate environment. In February 2022 I published a piece on credit conditions that covered using the TradingView platform to monitor secondary market credit spreads and conditions, why the declines in most credit ETFs had nothing to do with credit quality, and the basics of monitoring credit on the platform. That piece is linked below. The short course: 1) Corporates trade at a yield spread to treasuries. The spread compensates the corporate debt investor for the higher risk of default. 2) If Treasury yields rise, their dollar price declines. Since corporates trade at a yield spread to treasuries, if treasury yields rise, so do corporate yields (prices decline). 3) Since corporate spreads are generally far less volatile than Treasury yields, in most time periods, corporate total returns are driven by changes in Treasury yields rather than changes in corporate spreads. 4) The lower the credit quality, the wider the spread or default compensation. For instance, BBB rated corporates have more credit risk and thus more spread/yield above Treasuries than A rated bonds, 6.27 verses 5.65%. The difference of 62 basis points is the markets compensation (risk premium) for owning the riskier bond. The chart is a weekly chart of the option adjusted spread (OAS) of the ICE BofA Corporate Index back to the 1997 index inception. OAS is the standard way of assessing the credit spread compensation over and above the Treasury rate. The higher the OAS, the more compensation the investor receives. The bands are plotted 1 and 2 standard deviations above and below the from inception date median value. The large spikes higher in 2008 and 2020 are the great financial crisis and the pandemic. Spread compensation is only now back to the long term median. This after spending most of the last decade trading nearly a standard deviation rich to the long term median. I view this as the residual of the Feds QE translating to richer than normal asset prices. In short, there is no evidence of credit distress in the broad IG market. There is also, at least in this chart, no compelling value argument to be made. However, credit spread is only part of the equation. Remember that corporate total returns are more a function of changes in base or treasury rates than in changes in corporate spreads. In the next installment we will focus on the IG and HY markets in detail, some fundamental observations and finally, the correlation between rates and the major credit ETFs. 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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FRED:BAMLC0A0CM
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