High yield credit (HY) is a very diverse class of credit across all kinds of industries—financial, energy, healthcare, retail, on and on. As I have shown before, HY energy names are where the risk is and value is found in risk premium.
So I have been looking at ways to value HY credit reflective of how variated it is as an asset class. I did this by looking at the HY asset class from a point of view of credit swaps, because they provide liquidity. The inputs to the model are the credit swap spreads on different rating bucket that are roughly as variated as HY—A rated and BBB rated names. Using these inputs in a relative valuation model shows that HY is cheap to this model.
For such a simple model, the fit is impressive enough, diagnostics shown below. It actually warrants some calibration to make it more functional and simulation in a trade setting.
The implied level of HY credit spreads is near multi-year wides relative to realized spreads. This reflects a more cautious investor attitude towards more risky debt based on high volatility in oil prices seen and anticipation of rates rising impacting credit risk (the taper tantrum comes to mind). Show below is realized versus model implied credit swap premia, with the spread between the two indicated and measured on the right-hand scale.
As to whether we will see mean reversion or continued trending at these levels is a difficult call to make. A more cautious investor risk appetite is warranted given the shocks credit has seen. But the anticipation that higher interest rates will impact risky credit more profoundly than higher rated credit is not a certainty.
Given labor market, home sales, and general bubbly stock prices, it looks like a round of interest rate hikes is coming. I’m seeing from personal experience that the price for new hires out of school is spiking.
High yield credit depends on improving revenue and business fundamentals more than anything and these are somewhat idiosyncratic and more attuned to the business cycle than anything. As such, an expanding economy in need of a cool-down isn’t such bad news for HY. Investment grade credit, however, takes an immediate hit with every basis point higher.