Thursday, October 1, 2009

A look at credit yields and spreads

What is the outlook for credit-related yields? I think there are two main forces at work. For one, the underlying fundamentals remain difficult as rating downgrades are far from over while default rates do not seem to have hit their peaks yet. Furthermore, growth is far from self-sustainable and continues to depend on the life support provided by central banks and governments. On the other side, the environment of ultra-low short-end yields forces investors out the curve and out the rating scale in order to earn carry income. This is important for end investors as well as for pension funds but also increasingly for banks. Banks need to restructure and recapitalise their balance sheets. And here a steep yield curve as well as pronounced credit spreads help over time. Banks can fund themselves at almost 0% and can invest the money into either long-term government bonds or into credit-related paper (if they are usable as collateral with the central bank). In turn, demand for carry should remain strong as long as short-end yields are low. Furthermore, even though spreads have tightened sharply over recent months, they are still substantial as a percentage of the underlying risk free rate. Just as an example, a spread of 100bp does not appear that big in an environment where 10y government bonds are trading around 5-6%. However, if 10y govies are yielding only around 3%, such a spread would be equal to a return enhancement of 33%! In turn, the lower the yield level, the more attractive a given spread will become.

In order to derive some investment conclusions, I will take a brief look at history of the 1930s US.
The effects of the banking crisis in the 1930s on the bond markets

Source: St. Louis Federal Reserve

For the corporate bond yields I used the Moody's seasoned indexes which try to include bonds with remaining maturities as close as possible to 30 years. During the banking crisis in the early 1930s - and similar to what we saw last year - government bond yields were moving sideways to lower whereas credit-related yields were shooting higher, aggravating the banking crisis. Credit yields peaked in mid 1932 before entering a multi-year downward trend. Credit spreads showed the same behaviour as the chart below shows. This is remarkable as the recession lasted from August 1929 until March 1933. In between, the spread between Baa and long-term government bond yields had fallen from a peak of almost 800bp in May 1932 to a low of 420bp in autumn 1932 before rewidening temporarily. However, in 1932 real GDP collapsed by roughly 13% and fell by another 1.3% in 1933. Furthermore, even though growth rose to 10.9% in 1934 and 8.9% in 1935, credit yields continued to trend lower.
Corporate bond spreads entered multi-year downward trend following the banking crisis
Source: St. Louis Federal Reserve, ResearchAhead

However, what the above charts also shows is the huge volatility in the Baa yields and spreads vs. relatively stable AAA yields and spreads. Furthermore, there is a significant discrepancy between the AAA and Baa yields going into the next recession which started in 1937. AAA yields briefly moved a bit higher ahead of the recession but soon moved back on the path to lower yields.
Multi-year downward trend only briefly interrupted by onset of next recession for AAA bonds
Source: St. Louis Federal Reserve

On the other side, Baa yields once again moved significantly higher also starting a bit ahead of the recession but moved higher during almost the entire recession!
More pronounced and longer-lasting rise in yields for Baa bonds

Source: St. Louis Federal Reserve

I think that this diverging behaviour between high-grade bonds and their lower rated counterparts is likely to play out as well over the medium term amid the diverging forces between ongoing difficult fundamentals (and the risk of a double-dip) on the one side and the hunt for carry on the other. First the obvious: High-rated bonds will show a much lower volatility (no surprise) than low-rated ones, i.e. if one underperforms, the underperformance will be less. However, more importantly history during the 1930s suggests that the probability to underperform is also significantly lower in the case of higher-rated bonds. In turn, given the significant spread tightening since spring, I would not overweight high-yield bonds from a strategic asset allocation perspective. Rather, I would continue to overweight high-rated bonds vs. both, government bonds as well as high-yield.

Within the Eurozone government realm, fundamentally I favour Germany & France given that I think in economics terms they will outperform over the medium term. However, also here the need for carry is a strong spread-depressing factor and will act to tighten spreads further despite relative poor fundamentals of some sovereigns. Overall, I would suggest an overweight in Italy, Austria and Belgium and be neutral on Spain (amid the poor fundamentals) as well as Germany and France (amid the lack of yield pick-up). On the other side I would be underweight in Ireland, Greece and Portugal amid poor fundamentals and a lack of liquidity despite the yield pick-up. Finally, I would continue to overweight covered bonds in general as well.

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