“When I touched the bottom, I knew I should have learned to swim”
Andrew Bayer, “Tidal Wave” on Anjunabeats
Among other things, Resco’s team members found themselves seeking refuge in their respective music genres during lockdown. We have been through a few musical references in our insights here, and this time around find ourselves in the DJ spirit as we are thinking again about our “re-mixed” version of DTS (duration times spread), that we last discussed in January. Let’s rewind.
Back then we were responding to what we felt was a complacent perception of the ability of corporate bonds to generate excess carry over equivalent government bonds in a tight spread, high duration environment. We labelled the spread divided by duration data a “wipe-out” metric, and in re-organising the integers we were simply generating a series of the basis points required to eliminate a year’s excess carry (spread) for any credit universe we cover.
Spreads have travelled a long way since, with the previous moves wider being partly retraced in April. We’re digging out this remix again as volatility settles over an uneven recovery outlook and the dawn of a new round of central bank support is upon us.
In analysing behavioural patterns in the micro- and macro markets we cover, we saw record levels of pessimism during March and early April, which propelled a number of our indicators towards adding risk, the most compelling of which pointed towards areas of corporate bonds, where we subsequently moved to the highest allocation of risk since we launched. Our focus was on investment grade names, where our top down process moved from 15% to 66% at the end of March and then to 87.5% by mid-April.
We were not alone. The resurgence in popularity of the credit asset class, even among allocators who had turned their backs on it in the past, can be emblemised by the numerous fund launches of late in the credit space. Many managers see this as the dawn of an extended period of dislocation that (in spite of central bank support) will eventually see a sharp rise in corporate failure rates amidst a growing disparity between the winners and losers.
With that in mind, and following the retracement of spreads from the second half of March onwards, the buying theme already looks less clear cut, with the upside from investing across generic issuers already settling down. For active credit managers this means switching alpha engines back on to differentiate between issuers and sectors as economic destruction and central bank facilities collide.
The purpose of the wipe-out metric was to draw attention to the reality that, for a carry trade to work in 2020, you had to be convinced that spreads would remain stable or tighten, given the high sensitivities that would see your spread wiped out by a relatively benign move wider in spreads. The series simply followed the evolution of the basis point widening required to eliminate a year’s worth of excess carry (spread), at each month end, post GFC. We then considered the realised 12-month forward returns, from each point onwards.
What struck us then was that US investment grade (IG) readings were in fact sitting in line with the previously ‘least-attractive’ reading of this wipe-out metric, with low spreads and high durations. The widening of spreads in March saw the readings move towards the most attractive levels for this metric of the past decade. US IG, EUR IG and EUR high yield (HY) all moved from sitting in the fourth quartile of wipe-out metric outcomes at 2019 year-end to the first quartile by March 31st, an area where, perhaps unsurprisingly, you see higher returns on average for the subsequent 12 months. The metric reading for EUR IG has fallen back to the second quartile at the end of April, while US IG is on the frontier of the first/second quartile, an area where returns are, on average still healthy, but, as the scatter shows, more varied in distribution.
Looking at credit in this simple way suggests there is still some value in HY corporates. In the US, the April and March readings were in fact the two highest (most attractive) since the last crisis. Average 12-month forward returns of the first quartile outcomes for US HY have been over 13%, with only two returns less than 7.5%, being the 12 months following Sep 2010 (+1.8%) and Nov 2010 (+4.1%), with no negative returns across data points. The US HY universe premium also reflects solvency concerns related to oil and energy companies.
The reading for EUR HY sits just in the first quartile of metric outcomes at the end of April 2020. Looking at the other points in the first quartile of metric outcomes, we see that 12 month forward returns were negative for three data points, all of which fell around 12 months prior to the eurozone crisis.
Aside from those data points, returns topped 6.4% across the range and in fact were in double digits in all but four of the remaining instances. Nevertheless, we are more wary of EUR HY issuers for now, in part as we are positioning for fragilities in the Euro project to soon be exposed again, due to an anticipated uneven recovery on the other side of the crisis.
The efforts of central banks do not backstop the entire credit spectrum and could be perceived to have been engineered to stress test those most levered companies. Not to mention most HY companies employ less people and are less politically sensitive or headline garnering, should they fall to the wayside. This explains why overall we are not getting carried away with the prospects for HY just yet, while still in the discovery phase of the crisis, as idiosyncratic solvency risks are only set to grow.
As for IG, since mid-April’s peak in long positioning, we are already removing beta from the strategy to rebuild our cash pile. Our preferred route for adding exposure was a combination of the primary markets and issuers that had cheapened through the mechanics associated with drawing of credit lines. Yet this is already a less fruitful source of opportunities, so we expect to be digging deeper again into situational credit stories and niche issuers over the coming months.
Thank you for reading and don’t forget to comment, share and contact us for questions – the Resco Team
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