High-yield has long been disregarded as a barometer for risk appetite after the last economic slowdown (2011/2008) as interest rate has been pushed to zero thus yield-chasing investor was indirectly forced to chase HY for some years now, perhaps even with asymmetrical risk and “guaranteed” return. Generally speaking, any given securities will falls under the HY category given the potential deep downside risk and as a result, potential higher upside. According to SEC, high yield offers a higher rate because of it’s risk of default. Since we are talking about HY, I think it’s worth noting how Howard Marks of Oaktree Capital has offered good insights in my study in this realm and the market functionality as a whole.
Tracking the high yield spreads and default rate could be an insightful study in the amount of risk, or I should say the risk appetite on the market in relation to the risk-free rate. Here is the latest spread between US HY and the Treasury Benchmark for the past 5 years. Two points of observation is:
- Spring 2016 Market Volatility: Drastic run-up in Q3’15 – Q1’16 coincides with the equity market volatility in early 2016, which could be a correlation and/or causation to increase in global market volatility. As volatility increases, investors and market participants usually do not have the stomach to weather this if the thesis is not purely based on fundamentals (more in this from going through the 20+ memos that Mr. Howard Marks of Oaktree Capital has put out in the past decade). As a result, investors in high-yields will seek more % to compensate for the increasing default risk relative to the boarder market.
- Jan-Sept 2017 Inverse Correlation to Benchmark: Since the chart below is hedged on the Treasury benchmark, the increase in The Fed’s benchmark rate in the past few quarters should generally translate to positive correlation with HY spreads assuming all things, including risk, remains constant. However, per the chart, HY spreads actually declined further after the increase in the benchmark rate, which could implicate several things but one of which could be investor risk appetite did not translate directly with the appreciation of the benchmark rate, aka taking more risk relatively speaking. This is only one of the possible explanations but since the economic machine cannot be explained or ever will be fully, by these two variables along, this is only one of the theories. Also high-yield default rate would be an interesting study to look at soon.
However, if you extend the chart back to 1990’s, it looks like our market isn’t as immune to high-yield risk (default risk) as 2008. But based on the past two decades of data points (more the better but this is what we have), it looks like the appreciation in high-yield spreads usually precedes major market volatility (2016, 2011, 2008, 2000) generally speaking. Even though it’s positive correlation, it does not have a strong correlation with the % decline in market depreciation (i.e. US government bond downgrade in 2011 shows similar appreciation on the absolute level versus 2016 quarter-long market volatility but in terms of % appreciation and the time frame, 2011 was definitely more upward trajectory.
Moody’s Bond Covenant Index: MBCI is an indicator of the investor protection from the security issuers, the higher the # the lower the downside risk protection. MBCI has reached its all-time lows (as is the case for the past few months). However one thing to note is this chart only started aggregating data since 2011 which means it only has enough data for half a short-term business cycle. Sometimes, I question the validity in this # and index in general given this notion alone.
One thing to note is on the surface the data could be decent or bad, depending on your perspective, but if you are interested in digging deeper, look at these chart based on the ratings. For example, after reading Moody’s daily update for 9/28/2017 titled “Less Fear, More Debt” (perfect recipe?), the growth in the # of Ba+ or below increased substantially more than the investment grade ones. On the top level, what’s interesting is the default rate has generally been downward trending post-crisis but has grown substantially vs 2016. Another thing to note is these data sets are base on relatively notions not absolute so something to think about when digesting these charts.
The open-ended question here is could high-yield spreads be a good barometer of the risk appetite on the market (along with HY default rate + taking into consideration whether this is directly or indirectly caused by the ultra accommodative rate environment). Let me know what you think!
One thing to note personally and perhaps for the viewers, is that we have to be very mindful of the fundamental human flaws of always wanting to be right or at least desire to prove our own personal points right because we will search and even massage neutral data points to fit into our personal view point of the economy or other viewpoints in general.
And as Ray Dalio puts it:
“Rather than thinking I’m right, I went to thinking how do I know I’m right?”
*Currently reading the recently minted, Principles by Ray Dalio
I will be posting viewpoints on topics ranging from macro/equity/housing market to the function of society, to human psychology and more! Follow me on LinkedIn to get another perspective on the topics.
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