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Finding Value in High Yield

The established relationship between price and yields—price goes up yields go down, price goes down and yields go up—is ever true. But it doesn’t give you the whole story because high yield is a funny puzzler.

It’s always been thought of as an asset class that really isn’t, to be viewed instead on a case by case basis. These businesses are typically cash poor, so the balance sheet doesn’t matter as much as free cash to debt. Free cash flow can bounce all over the place quarter-on-quarter, and thus you see HY bond prices move a lot more like stocks that IG bonds. With IG, it is about balance sheet strength; with HY it is all about generating cash.

Things are changing in North America, at least from the perspective of high yield indexes. The sheer volume of high yield credit is making it meaningful to talk about it as an asset class. It is meaningful to actually decompose high yield into grades based on ratings to some extent. You can see a distinction based on yields. See below: BB, B, and CCC yields all move the same way directionally. It is night and day compared to their closest investment grade cousin BBB. The difference is the extent of the yields spikes (sell-offs) you see in the riskiest debt.

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With yields you can see a sell-off easy enough, and general de-risking sentiment even easier. All corporate bonds have some mixture of equity and some mixture of treasury in them. Because of the importance of free cash flow mentioned above, the riskier the bond, the more equity-like it behaves. So in bonds in distress you have bigger moves in price, yield, and losses due to default—total returns. Credit guys don’t care about earnings because it is harder to fudge free cash flow.

It is in total returns where you see the real damage in credit indexes. Check it out.

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It is in total returns where you measure performance/underperformance. I’m going to be a credit guy instead of a bond guy here. Given that you have a sufficiently large pool of fixed income instruments in an index, you aren’t likely to face the proverbial apocalypse of total loss. Not that there isn’t a lot to lose, especially with the typical leverage deployed in the bond game. What high yield credit indexing offers is exposure to the rapier point of risk sentiment. This is why money goes long HY CDX as a proxy hedge on just about anything structured or securitized.

The current sweet spot is B rated credit. Yields haven’t widened much against BB. It is underperforming the rest of high yield on top of that. Given depth of capitalization in an index, B gives you the best exposure to a quants best friend… mean reversion.

Aside from VIX, there is nothing more mean reverting than a credit spread.

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