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Both US and European credit markets have delivered a fairly positive yearto- date performance; supported by falling political risk, excess returns versus underlying government bonds proved to be particularly strong for EUR corporate bonds in the second quarter.
On the back of this rally, it is unsurprising that valuations generally tightened. In this piece we address the current situation in IG and HY corporate credit valuations on both sides of the Atlantic, using our fair value models, while also taking into account the implied default risk for HY bonds. We also assess the potential impact on spreads of higher bond yields, through the empirical link between absolute and relative credit risk premiums.
A look at our regression-based fair value models and their current indications
Results and inputs of our models covering US IG and HY corporate bonds
The first two charts show the comparison between actual spreads and our modelled spreads for US IG and HY corporate bonds since 1989: the graphs underline the extent to which valuations got rich in the last two quarters for both market segments. The latest numbers show that IG and HY spreads are respectively trading at around 40bp and 110bp below their fair values. Our regressions to estimate the fair value spreads paid by US corporate bonds are based on fundamental inputs (i.e. the ratios of non-financial corporate profit to GDP and non-financial corporate debt to GDP), the underlying US treasury yield to maturity (for the same duration), equity implied volatility (VIX), and for HY only, the results of the senior loan officer opinion survey on bank lending practices, reporting the ongoing tightening or easing of conditions applied by banks to C&I loans. Equity implied volatility is particularly effective at explaining spread levels during recessionary phases or crises. Bank lending standards assume a more important role for HY issuers, as speculative grade issuers are more vulnerable than IG companies to credit crunch phases or a prolonged high level of risk aversion. Finally, the US Treasury yield to maturity is pretty effective at capturing the change in situation following the Great Financial Crisis. Data included in the computations are quarterly and cover almost the last forty years, during which the last three macro and micro cycles took place.
Results and inputs of our models covering EUR IG and HY corporate bonds
The valuation picture for EUR-denominated corporate bonds shows a similar gap between the fair and market spreads indicated for US corporates, but despite the ECB’s ongoing CSPP, this gap is much smaller in Europe than on the other side of the Atlantic. In a nutshell, valuations no longer look cheap in the eurozone and fell in rich territory, but are not as stretched as they appear in the US.
The charts show that market spreads recently fell below levels that can be explained by their usual drivers. This is the case for both EUR HY bonds and EUR IG bonds. Our regressions are based on leading macro indicators, equity implied volatility and sovereign risk premiums: these inputs are different from the variables used for US spreads, as the market history is much shorter and the sovereign crisis introduced a new key variable into the equation. HY spreads, in particular, look relatively consistent with the recent level of the composite PMI, which measures the momentum in expected macro growth. With respect to the historical relationship, they look slightly rich with respect to equity implied volatility, while they look much tighter in the usual link with systemic risk measured by periphery debt spreads. To summarise, the latest numbers point to fair spreads that are respectively 30bp and 10bp higher than current market levels of HY and industrial BBB-rated bonds. Within the IG market, the valuation picture for senior financials is not substantially different from non-financials: among financials, subordinated debt still looks better positioned in terms of residual valuation potential, despite outperforming the equity side by some distance in recent months.
US and EUR HY spreads not so tight given the default risk
As outlined in another Thematic Paper “US HY default rates: trends, projections and perspectives”, the short-term picture for default rates should improve slightly in the US and is likely to remain reasonably rosy in Europe. One of the main counterintuitive findings of recent years’ empirical market experience is that a low yield, low growth, low inflation environment keeps default rates in a sort of new “low regime” that is unlikely to be disrupted in short order by an over-aggressive stance on the part of central banks or by the return to higher macro growth potential. As such, despite stretched valuations and credit yields close to multi-decade lows, it is important to note that spreads are not at extreme levels relative to their history. In keeping with a much lower default world, the spreads required to compensate for average default risk should also be somewhat lower than in the past.
Accordingly, in order to test what level of medium-term default risk credit premiums are paying for, we ran an analysis based on a 5-year horizon and used two different assumptions for the recovery rate: 40% (the long-term average) and 20%, which is more conservative and more in line with recent trends, which have been dominated by defaults in commodity-driven sectors.
In the case of a 40% recovery rate, current spreads offered by mid- and low-rated debt in the US (and more recently in Europe too) imply a default rate only slightly above or in line with long-term historical averages. In contrast, at current spreads, BBs offer a bigger cushion, positioning themselves halfway between the averages and the worst 5-year cumulative historical defaults. If the assumed recovery ratio is lowered to 20%, CCC current spreads no longer cover even the historical averages . B-rated spreads are in line with these, while the BB premium still offers a small cushion versus historical averages.
Shortening the horizon to one year, a breakdown of the most recent trends by rating category shows very different numbers and stages. Moving on to the numbers and comparing spreads with a one-year default rate, CCC-rated spreads tightened to current levels in the region of 880bp from peaks 18 months ago of close to 2,000bp, but default rates have only just started to fall: in June the default rate for CCC-debt was still high at 15%, though down from 21% in January. BB-rated also debt tightened, to 230bp, but default rates were already back to zero in January and February: the fall from the 1.4% June peak was rapid. Finally, the default rate of B-rated debt rapidly fell from 5.2% last October to 1.7% in February, while spreads tightened to 380bp.
Moving from absolute to relative credit valuations: the link between spreads and bond yields
Moving from absolute to relative valuations means comparing US Treasury yield levels to the ratio between corporate yields and government bond yields. As the graph shows, the credit risk premium as a percentage of the yield is not steady but depends on the levels of the latter. Investors accept lower relative valuations when returns are high, but require a high relative premium when yields are low. This relationship also remained intact after the Lehman default: the ratio has recently fallen from 5.7 times a year ago, to 3.9 times before the “Trump effect” in October 2016, and now to 3.2 times (in red). The fall in the ratios relates to the increase in Treasury yields, from 1.35% (September 2016), and the fall in credit spreads.
What has changed after the Great Financial Crisis is shown in chart 7: the fall in bond yields into a new “corridor” with a 2% average corresponds to the new regime of yield ratios, with new median and standard deviations. The Lehman spike in the gap between market spreads and fair values was mainly due to a maximum liquidity premium, probably the highest ever recorded. Added to this, however - and especially in recent years - our guess is that investors tend to require a higher premium on corporate bonds relative to Treasuries when the riskfree rate is lower, mainly in order to maintain an adequate credit risk premium (the credit risk portion currently represents around two-thirds of the overall yield offered by a US HY bond, contrary to much lower proportions in comparable times (28% in 1997 and 33% in 2007).
In light of the above, given an expected change in Treasury yield, we may infer an expected spread level from the yield ratio consistent with a movement of this nature in the US Treasury market. We ran this exercise for both US IG and HY bonds, assuming two scenarios: a rise in (for the same corporate bond duration) Treasury yields of 30bp and 50bp. The results suggest that HY spreads would very likely widen by 50-60bp, while IG spreads would rise by just 5-15bp. In other words, HY bonds are therefore likely to suffer more than IG bonds in a rising yield environment according to their historical relationship with Treasury yields. This is not inconsistent with the fact that the usual inverse correlation between spreads and yields occurs in phases of the cycle very different from the current one. This cycle has lasted quite a long time, and the early recovery phase is already far behind us: in early recovery phase, companies are experiencing growing profits and strengthening pricing power after having compressed leverage.
Turning to EUR-denominated credit markets, the fall of core bond yields into negative territory means that this kind of analysis is unfortunately no longer viable. Although yields had risen from their lows on the back of the improved macro picture and the ECB’s expected QE tapering in 2018, European credits are in a much better position than US corporate bonds, and this is not only due to the ECB continuing to support them, though with lower purchase volumes in 2018. Within the entire universe of EUR-denominated debt in the short maturity segment, HY bonds and IG financial subordinated debt are the only instruments still trading in positive yield territory. The opportunity cost of moving from spread products into risk-free bonds is much higher in Europe than in the US in short to medium maturities: the numbers show that out of total outstanding debt of EUR 2.4 trillion in the 1-3 year segment, only EUR 120 billion relates to HY and subordinated financial issues, accounting for almost all of the remaining positive yield. The picture is not much different in terms of yield concentration in the 3-5 year segment, where out of EUR 2.4 trillion debt, HY corporate bonds still make up 44% of remaining yield, while IG corporate bonds account for another 37%, even though they respectively represent just 4.4% and 24% of the entire segment’s debt. Furthermore, looking at the whole curve, the trade-off needed between lowering credit risk and increasing duration risk in order to reach the same yield levels is still significant at the time of writing. A 4-year BBB rated corporate bond offers a yield in line with a 15-year German bund (an 11-year gap, therefore), while the increase required in duration risk would rise to around 20 years in the case of a shift from a BBB 7Y/8Y bond back into the German curve. Periphery sovereign bonds generally offer a better profile than IG corporate bonds in maturities longer than 5 years, given their steeper curve. Nonetheless, on average, on a 3-year horizon a BB-rated bond offers the same yield as that offered by a BTP with a 10- year maturity, while a B-rated corporate bond offers the same yield as a 25-year nBTP. Despite forecasting a steeper German curve on a one-year horizon, we still expect a stable scenario for short-term bund yields in negative yield territory over the next 12 months. The steepening should reduce the above mentioned tradeoff between credit risk and duration risk, the yield being equal, but is unlikely to materially change the relative value within the 1-5 year curve segment.
Our models show that although valuations look rich versus their underlying factors on both sides of the Atlantic, US credit spreads look more stretched than EUR credit markets for both IG and HY, despite the ECB’s direct support for European credit through the CSPP. Current yield and spread levels point to lower expected returns in the next years (but this is a common theme throughout the fixed income world).
Within the HY universe, low-rated segments also look stretched in terms of the implied default rate: this is especially true in the US, with CCC spreads fairly tight versus their current 1-year rolling default rates. High-quality (BB-rated) HY spreads, on the other hand, still provide a bit of a cushion for credit events in both USD- and EUR-denominated debt: in the current low default rate environment (low yield, low growth, low inflation), BB-rated spreads still imply a default rate higher than historical long-term averages.
In a rising yield environment, US HY spreads look more likely to rise than US IG spreads, according to their historical yield ratio-Treasury relationships, which would not be inconsistent with this late phase of the macro cycle. Moreover, thanks to the ongoing negative rate environment, European credits are in a better position than their US counterparties in the 1-5 year segment, where the opportunity cost of moving from spread products into risk-free bonds is higher in Europe than in the US. The likely steepening of the bund yield curve over the next few quarters will reduce this opportunity cost to some extent, but risk-free bonds are likely to remain in negative yield territory for some time to come, keeping the search for yield in the low duration segment.
Credit risk currently represents around
In a rising yield environment, US
Investors require a high relative premium when yields are low.”
Low-rated segments also look stretched
The opportunity cost of moving from spread
The rise in bond yields since Trump’s election is not surprising, but it raises a crucial question: are we witnessing a radical reversal of the underlying trend that has been driving for decades (i.e. bonds yields decline), have we ended with abnormally low rates, or is it “simply” one of those many corrections that we regularly attend? Clearly, is it a regime shift, a change of level, or a correction within a fluctuation band? After analysing the usual and specific triggers for bond yields increases, five conclusions have to be pointed out:
Global Head of Research