Does Bargain Hunting Matter Anymore? In High Yield It Sure Does.
February 20, 2015
I’ve talked about bond guys who essentially take a rating agency approach to buying bonds. They go out in terms of maturities, they go up and down in terms of capital structure, and they take more or less credit risk. There are other dimensions, but the point is clear enough.
Credit guys look to the interconnections between different risk classes to identify the odd man out. If he is rich to expectation, the credit guy shorts. If he is cheap to expectation, the credit guy is long. This works pretty well in fixed income, because there is nothing short of VIX that mean reverts like a credit spread. Credit guys are quantitative, which is objective and rule based, but weak assumptions can hurt their performance. They compensate by building flexibility using synthetic as opposed to cash positions.
Bill Gross is a brilliant integrator of the two worldviews: he is bond guy that can horse-trade and hold to a position with tenacity. But he saw as early as the mid-80 huge value in what credit guys could do in an integrated, uber-financialized, over-banked universe in which we float somewhat aimlessly. Bill Gross built an empire based on clever derivative overlays.
But what is left for the bond guys? When massive credit flows signaled by currency moves and policy rates variances drive correlations and volatilities across all asset classes, does picking a money-good bond serve any purpose?
They do. Let’s use a credit-guy perspective to make the case.
This is simplistic, but broadly indicative of realities. A credit guy doesn’t think of a business in terms of the widgets it makes and sells. He thinks of a business as a set of variable cash-flows discounted based on future expectations. These cash-flows can be very risky and the carry he receives in return for the risk makes it high yield. Less risky bonds offer less carry. Call this investment grade or high grade. Any bond in his framework is part reference bond like treasuries and part equity risk. It is a function of risk how much like equity or treasury a bond behaves.
A bond guy will stop you at this point and make a legitimate point. What if the cash-flows are being mispriced in terms of carry? That is the value prop of the bond guy: discerning if widgets are hot item or not on a go-forward basis.
A credit guy easily gets lost in this because all the cash flows he looks at roll into aggregated cash-flows across a number of businesses that comprise an index. It really doesn’t matter about the outlook for widget sales, because the index offers presumed diversification. He would tell the bond guy that he may be right about mispriced risk/carry, but it doesn’t matter on the average.
Who is right reduces to whether or not there is a residual above and beyond correlations and averaging out returns in the financial world. You bet there is, even at the level of credit indexation. Especially in High Yield. Have a look.
I pulled in the 10Y tsy as a reference bond, IG, HY, SP500 as a risk signal, and JGB10 as a capital flow factor. There is plenty of residual left over that speaks to idiosyncratic—business specific—risks. Carefully weighing these idiosyncratic risks are where the money is for bond guys.
And here are the findings for investmenr grade.
In either IG or HY asset classes, there is plenty of room left over for shopping around and finding value. The big risk is that a large part of this model residual is not idiosyncratic as much as just large unforeseen shocks that blow up all valuation efforts.
Funny but true: the credit guys and bond guys are merging. For example, it is increasingly the case that fixed income consists of parking money in a long CDX IG main position while waiting for some cash issuance to come along. Face it, that is a pretty unimaginative deployment of capital. So don’t scorn a bond picker for being discerning where he puts his money. It is a choice of flash over the staid.
Don't scorn a credit guy for keeping a cash bond at arm's length, either.