Friday, December 12, 2014

Swap spreads say junk bonds look attractive

High-yield debt (aka junk bonds) has suffered almost a 10% drop in value since oil prices started to collapse last June. But 2-yr swap spreads have only increased about 10 bps over that same period, and are currently trading in "benign" territory (20-25 bps). This suggests that the junk bond selloff owes more to fears than to any fundamental deterioration in the economic outlook.

The chart above compares 2-yr swap spreads with the spreads on high-yield corporate debt. Swap spreads have often been good leading indicators of the health of the financial markets and the economy. In "normal" times they trade around 20 bps or so. Prior to the Great Recession they rose to "troubled" levels, and were a good predictor of tougher times to come; they then went on to be the first to signal the end of the recession well in advance. The recent rise in swap spreads has merely taken them from unusually low levels to "normal" levels. As such, this suggests that the more than 200 bps rise in junk bond spreads (the dividend yield on HYG has risen to just under 6% in the process) has more to do with fears that lower oil prices will trigger higher default rates among corporate issuers than it does with any fundamental deterioration in the broader economy. Yes, many energy-related issuers with heavy debt burdens are facing difficult times, but they are a relatively small minority in the greater scheme of things. Businesses that consume a lot of energy are doing very well (UAL, for example, is up some 60% since June).

Yields on high-yield debt are approaching 7%, and at that level investors are being offered a substantial yield pickup over Treasury debt, and a decent cushion against further declines in price. It's the bond market's version of "walls of worry."

8 comments: said...

Interesting post, Scott. This is more fear being brought up by concerns of fracking oil patch high yield issues. This is but a small portion of all issues. I had just bought some Vanguard High Yield Corporate Fund VWEAX. Goldman Sachs issued a report on the high yield bond market in this same vein a couple of weeks back.

zumbador said...

SCOTT…...This is NOT a reference to swap spreads but I do have a question…..Why is it that the investment markets whack out to the downside when oil goes up (which seems to hammer the consumer and business in general) and THEN when oil drops like a rock and the consumer and business seem to be able to retain more of their own money the markets and especially the media whack out and create tons of "drama"??? causing the investment markets to get smacked to the downside!!! The long term picture would seem to me to be very favorable for both the consumer and business in general. Thanks for ALL the excellent data and info you provide.

Scott Grannis said...

zumbador: to answer your question, my best guess is that the market is just plain nervous. Risk aversion is still everywhere, but it has gone down a few notches. Nevertheless, the stock market has gone up so much that there is lots of concern that something, whatever, will trigger a big selloff. A big drop in oil prices is a shock to many (big changes always create nervousness), and so it's fertile ground for panic. But in the long run I think things will sort out for the better.

Benjamin Cole said...

Another place to look for yields is in the mortgage REIT market. I suspect we will see very low inflation and interest rates for many years. But some mortgage leads are offering near double-digit yields.

steve said...

I've been trading corp HY successfully for over 20 yrs and I can tell you emphatically that it is a very emotional trend driven market. aka when prices are falling, DO NOT BUY!. the entire market is maybe $1.5T and that is up 50% this year. so it is quite illiquid-which is why it trends so well. I'm optimistic I'll get a nice entry point sometime in near future but I'm not going to try and pick a bottom.

BTW, it is also remotely possible that HY is foretelling further turpitude in the future is in '08. I do NOT expect it but this is how these bonds behave during crisis.

William said...

OECD Composite leading indicators point to continued weak growth in Europe

12/11/2014 - Composite leading indicators (CLIs), designed to anticipate turning points in economic activity relative to trend, point to continued weak growth in Europe but stable growth in most other major economies and in the OECD as a whole.

Amongst major economies stable growth momentum is anticipated for Canada, the United States, Brazil, China and Russia.

The CLI points to growth losing traction in Japan though this may be related to one-off factors.
Within the Euro Area, the CLI continues to point to a loss of growth momentum, with stronger signals of a slowdown in the case of Germany and Italy.
In France however the outlook continues to suggest stable growth momentum.

The CLI for the United Kingdom indicates that growth may ease, albeit from relatively high levels.
India is the only major economy where the CLI points to a pick-up in growth momentum.

William said...

Even Before Long Winter Begins, Energy Bills Send Shivers in New England

SALEM, N.H. — John York, who owns a small printing business, nearly fell out of his chair the other day when he opened his electric bill.

"For October, he had paid $376. For November, his bill came to $788, a staggering increase of 110 percent. “This is insane,” he said, shaking his head. “We can’t go on like this.”

For months, utility companies across New England have been warning customers to expect sharp price increases, for which the companies blame the continuing shortage of pipeline capacity to bring natural gas to the region.

steve said...

completely off subject but to william's point, we live on lake winnipesaukee in NH (read COLD) and energy is expensive. virtually everyone up here uses propane as there are no nat gas pipelines (NH residents don't like to tear up the scape) and that stuff is crazy expensive. add in the electric bill and yeah you don't want to be penurious and live here. that said, I am NOT shutting down the hot tub!