The recent correction in corporate credit markets has not been down to fundamentals, says George Muzinich.
In recent weeks, corporate credit markets have experienced a correction. But this correction has not been the result of credit fundamentals, which remain strong. Over the period 22 May – the date of Fed chairman Ben Bernanke’s testimony to the US Congress – to 6 June, US high-yield markets were down 2.45%. This performance can be broken down into two phases.
The first phase of the correction was from 22 May to 28 May and was a re-pricing due to concerns over the end of the Federal Reserve’s policy of quantitative easing. Over the period, credit markets generally behaved as expected, with rate-sensitive fixed income declining considerably more than credit-sensitive fixed income.
For instance, the 10-year US Treasury (BofA ML US 10-Year Treasury – GA10) fell by 1.61%, investment-grade corporates (BofA ML US Corporate Master – C0A0) declined by 0.91% and US high yield (BofA ML US High Yield Cash Pay – J0A0) declined by 0.44%. Within high yield, BBs fell more than CCCs.
While high-yield markets can be sensitive to government rates over the short term, over the medium and longer term, the asset class has generally proved resilient. Over the last 20 years, there have been 32 quarters in which the 10-year US Treasury experienced negative performance. In each of these periods except one, US high yield has outperformed the 10-year US Treasury. High yield actually generated a positive return in 85% of these quarters. In addition, over the same 20-year period, the correlation between US high yield and the 10-year Treasury has been -0.10.
The reasons for this strong relative long-term outperformance are fourfold. First, Treasuries tend to perform poorly in improving/strong economic environments, while corporate credit spreads generally tighten in such periods. Second, high yield’s excess spread over Treasuries provides a buffer to rising rates. Third, the high-yield market’s duration is relatively short, and is currently less than four years. And fourth, institutional investors need fixed income exposure, and, in periods of rising interest rates, these investors typically would be well served by reducing their fixed income allocation to governments and investment grade and maintaining or increasing their allocation to high yield, which is better able to absorb an increase in interest rates.
The second phase of the correction was the period 29 May to 6 June. This phase was characterised by a re-assessing of risk-assets globally rather than by a focus on rates. The US high-yield market was down 2.03%, the US equity market (S&P 500) was down 2.17%, and the VIX, which measures market volatility, increased from 14.83 to 16.63. By contrast, over this period, the 10-year US Treasury was roughly flat.
This phase of the re-pricing was characterised by high-yield market behaviour similar to August 2011. Short-term money, often from retail investors in ETFs, left the asset class. Both the JNK and HYG – the two main high-yield ETFs – experienced noticeable outflows. During the period of 22 May to 6 June, the JNK ETF was down 2.9% compared with the US high-yield market that was down 2.45%. The JNK experienced a roughly 10% outflow over this period, taking the ETF share count to a level last seen at the beginning of 2012, suggesting a meaningful amount of speculative funds left the market. While the exiting of short-term money from the asset class has a mark-to-market effect, it removes from the market investors who do not understand the asset class and creates technically driven opportunities.
High-yield company fundamentals remain healthy – both cash levels and interest coverage ratios remain above historical averages. Companies have aggressively refinanced, pushing the debt-maturity wall out to 2015 and beyond. Defaults are low, and the outlook remains benign. We are forecasting a default rate of less than 2% for each of 2013 and 2014 compared with a long-term 25-year average of 4%. In short, credit risk is minimal compared with historical levels.
The yield on the high-yield market has increased considerably to more than 6% (BofA ML US High -Yield Cash Pay – J0A0). One key question is whether current valuations compensate investors for both credit and duration risk. One way to answer this question is to consider implied default rates at current market levels. The five-year Treasury is currently yielding 1% (BofA ML Current 5 year US Treasury – GA05). This implies a breakeven default rate for the high-yield market of 5.7%. In other words, with a default level of 5.7%, investors are indifferent between owning a five-year Treasury and high yield, given historical recovery values and holding all else constant.
How does this implied default rate change if five-year Treasuries were to have a very sharp move higher? At a Treasury level of 2%, the breakeven default rate is 4.2%, and at a Treasury level of 3%, the breakeven default rate is 2.7%. Even in the case of this very extreme move, a 2.7% default rate is higher than the 2% default rate we and JP Morgan are forecasting for the high-yield market. In other words, at current levels, the spread seems to more than compensate investors not only for credit risk, but also for duration risk. It is impossible to perfectly time an investment or predict short-term market behaviour, but, for investors with a longer-term horizon, the current market correction may provide an attractive opportunity.
George Muzinich is founder, chairman and chief executive at Muzinich & Co