Thursday, May 30th, 2019

Credit Wobble

When headlines are dominated by a bout of weakness in global equities, it may seem perverse to write about the credit markets. However, they have just produced a signal we did not expect – not quite so soon, at any rate – which could act as confirmation of equity weakness, if it gets worse. Three weeks ago, the recommended weighting of High Yield Bonds started to fall in our main US$ fixed income model. This was the first downward move since the beginning of the year. Even though they are still rated neutral, at the current rate of progress they could be downgraded to underweight by the middle of June.

Part of the explanation is, of course, the move back towards duration as medium-dated Treasury yields have fallen. However, in our model, the decline against Investment Grade has been faster and has already reduced High Yield to the equivalent of an underweight, if we were just comparing these two categories. There are two well-known sector biases which affect this relationship. High Yield is dramatically overweight in the Energy sector thanks to the US shale boom, while Investment Grade is overweight Financials. So, we need to ask whether either of them is responsible for the change in direction, or whether there really has been a like for like deterioration.  For the sake of simplicity, we look at direct sectoral comparison, using our cross-asset sector models.

Despite recent strength in the price of oil, which should benefit production and exploration companies more than the integrated majors, High Yield Energy has been rated underweight relative to Investment Grade Energy for the whole of 2019. There was a modest bounce in April, but it didn’t last long and was never as powerful as the rally in High Yield overall. High Yield Financials rallied against Investment Grade for most of the first quarter, and have not sold off by very much since the peak, so they can’t be responsible for the downgrade of the asset class as a whole.

The clearest message comes from Industrials. This is the one sector where it is completely legitimate to make direct comparisons between the two asset classes without having to account for different sector weights or different business models among the issuers. High Yield Industrials were rated overweight relative to Investment Grade Industrials as recently as the middle of December. They fell to an underweight but bounced back to neutral in January before starting a consistent downtrend with lower highs and lower lows, which has been in place since March. In fact, the Industrials sector is the biggest single driver of the decline in our recommended weighting for US High Yield relative to US Investment Grade. It is hard to interpret this as anything other than a loss of confidence in risky credits.

Few investors dispute the idea that distress in High Yield is a bad lead-indicator for equities. The issue is how to get the correct read-across from the relationship with Investment Grade. Looking at the last 22 years, it appears that the signal does not become critical until the probability of High Yield outperforming Investment Grade gets to zero and stays there, even if there is a subsequent rally is Investment Grade also becomes distressed. We are not there yet, but we could be in a few weeks, if the situation were to deteriorate from here.

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