Equity Will Continue to Catch Down to Credit

I believe that an interest rate hike has been priced in. The impact of 2x 25 basis point hikes late this year followed by early next on funding and leverage has already played out. As such, there has been little interest in credit for most of 2015.

It hasn’t been rate hikes that have depressed high yield bonds—at least not directly. It is oil prices. As the market priced in higher US rate differentials it priced in a rising USD which in turn smote oil and other energy prices. The organic impact of cheap on revenues is what has crushed high yield at the index level and the set-up for a dispersion trade has not been particularly good as non-energy names are by no means cheap and buying energy names will lead to an early funeral.

A good measure of how all grades of bonds have been affected by oil prices is shown below. Bond yields for names in the S&P 500 index are at multi-year highs. More importantly, in terms of standard deviations, yields are breaching levels where stat arb totally freaks out.

Investment grade has underperformed equities YTD—bypassed by money moving into the term risk government securities early in the year, following nervously any talk of a Fed rate hike, and now smarting from the same oil price declines that have beat up high yield. Throughout the year it underperformed equities which almost always seem to be stuck in a world of their own, with little connection to the good old balance sheet.

So as a result of this, I took a view that investment grade would outperform its brethren going into the fall and winter in spite of the threat of rate hikes. This outperformance is due more than anything to the technical of issuance. US investment grade supply has been heavy but this is tapering off. As the realization that the global economy is entering a renewed state of malaise, earnings will disappoint. It makes perfect sense that equities will catch down to credit, especially down to investment grade.

We say the first signs of this last week, followed by a relief-drive and credit supportive decline in USDJPY plus some credit swap liquidity. It was not to last. Today we saw another full melt-down in equities, this time more broad-based. In this environment, secular themes point to weak growth. Heavily-indebted countries, companies, and households continue to reshape the financial landscape.

Investment grade credit in these tense times as equities are by no means freed from multiple expansion, but high yield is always where you find the fireworks. In high yield you have good spread (left –hand scale), and there is little more mean-reverting than a credit spread. And there has been a lot of hedging activity being put on in high yield (see the basis widening of IBoxx to the CDS tranche rivalling the CDS panel roll back in March). This is more an indicator of elevated risk aversion because the hedging is not solely motivated by investors in high yield bonds. Lots of risky debt and asset backed gets hedged with CDX.NA.HY. Not so much with the European analog X-O bonds.

I know, I know… talking about bargains in high yield is like a cricket trying to shout down an army of cicadas. Trust me, this too will pass.


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