Dec 03, 2015 | Post by: Roman Chuyan, CFA Comments Off on The Great Credit-Equity Divergence

The Great Credit-Equity Divergence

“– Now, here, you see, it takes all the running you can do, to keep in the same place.”

The Red Queen in: Lewis Carroll, Through the Looking-Glass

I’d like to highlight the state of the high-yield bond market (or “junk bonds”), defined as bonds rated Ba1/BB+ or lower. Bond markets in general are critical to our credit-based economy; and HY is the riskiest debt segment. As we’ve seen time and again, credit follows a boom-and-bust cycle that can itself broadly influence the economy and markets. When a credit downturn happens, hard-headed bond managers who are concerned with getting their money back, often spoil the equity party.

My goal for this analysis was to see whether HY credit spread served as a leading indicator of previous severe downturns: do HY bonds indicate that a severe downturn (a recession, a bear market) is likely?

HY bonds are typically highly correlated with equities – both markets are considered risky, and follow the general ebb-and-flow of investor sentiment. However, they diverged starting last summer, when HY bonds began to lag while the S&P 500 reached an all-time high on July 20, 2015. The August correction in equities closed the divergence temporarily, but it re-opened as the S&P rebounded in October (3.2% total return year-to-date). At this time, prices and yields for HY bonds (-4.7% YTD) and HY bank loans (‑3.2% YTD) suggest that a cyclical credit downturn is well underway.

SP500 vs HY performance - tactical management

Credit oils the wheels of commerce. In our credit-based economy, every dollar borrowed adds several dollars to economic activity. But, as in Lewis Carroll’s Red Queen’s race, credit has to keep growing in order to “keep in the same place” and support a certain level of economic growth. Credit doesn’t have to contract – a mere pause in credit growth hinders economic growth.

I tried to establish whether there was a level of yield or spread that served as a warning indicator for severe downturns. It appears that a turning point occurred when the HY index spread sustainably widened to above 6.25%, as well as the spread on the higher-rated BB portion of the index widening above 4%. Prior to this year, this has occurred three times since 1996: in Aug 2000, Jan 2008, and Aug 2011. I think this adds color to our understanding of the current market situation. While HY spread widening wasn’t always a reliable leading indicator of a severe bear market, it was such an indicator in 2000 and was reasonably good in 2008.

HY Spread and the S&P 500 (1996 – 2015)

HY spread analysis - tactical investment

Source 2: analysis by Model Capital Management LLC

While I think this adds color to our understanding of the current market situation, I can’t conclude that HY spread widening was always a reliable leading indicator of a severe bear market. It was such as indicator in 2000, was reasonably good in 2008, but it wasn’t in 2011 – spreads tightened back after a moderate correction. In addition, the HY spread is not the only indicator that influences equities – we have to also consider valuation and economic factors.

Still, the current HY prices and spreads, 6.4% for the HY index overall and 4.08% for BB, suggest considerable stress that typically occurs during a credit contraction. This is especially evident in the Energy sector in the U.S. and globally. For example, Spanish renewable-energy company Abengoa SA, with 8.9 billion of total debt, sought protection from creditors last Wednesday, Nov 25 – as far as I know, the first default of such significant size in the current credit cycle. After a 60% plunge in oil price, I think we should be prepared for more bad news to come from the Energy sector in the U.S. and abroad.


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