This Opinion article in Bloomberg entitled “What Does a Junk Bond Even Mean Anymore?”
discusses the tightening of spreads across the US dollar corporate credit curve, especially between BBB and BB. It inspired me to take a look at the yields myself, and these are my quick conclusions and supporting data, all of which came from FRED. and uses the Intercontinental Exchange (ICE) data provided by BofAML. Let’s first look at yields over the last five years (bottom line is 10-year constant maturity UST):
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This yield chart shows two things. Firstly, in periods of uncertainty when volatility is increasing, credit spreads widen quickly and significantly in non-investment grade but tend to widen less – or even tighten - in investment grade credit, illustrating a typical flight-to-quality. This occurred in fact in the 4Q2015 / 1Q2016, as GDP growth was slowing in the latter half of 2015, bottoming at 0.1% GDP growth in 4Q2015. Over the six month period from the end of June 2015 to the end of December 2015, investors moved into higher quality bonds, driving yields wider as you moved down the credit curve. This was the yield movement across the credit curve in 2H2015, supporting this point:
By early 2016, the outlook brightened for the US economy and yields began to narrow and normalise throughout the year as the graph illustrates.
The second thing that this graph illustrates is the steady march down of yields across the credit spectrum since this time last year, when spreads temporarily blipped up as the equity market deteriorated in 4Q2018 (mainly due in retrospect to Fed tightening). Yields on non-investment grade rated bonds reached their recent peak the last week of December 2018. And as you might recall, the Fed raised rates for the final time in December 2018, but in doing so, also cleared the air as far as future rate rises, creating the foundation for what has been a remarkable recovery across nearly all asset classes, including credit and equities, during 2019. The Fed did indeed become dovish during this year, lowering the Fed Funds rate three times. The credit market loved it!
So having looked at yields, let’s take a quick look at credit spreads. The graph below illustrates the ICE BofAML spreads by rating category (AAA, BBB, BB, B and CCC) versus the 10-year constant yield US Treasury.
This graph is not that different from the yield graph presented earlier, but it clearly shows the convergence of spreads in the AAA to the B categories during 2019, while spreads on the CCC category have widened at the same time. This illustrates a sub flight-to-quality within the high yield universe, as high yield investors have opted for higher rated junk at the expense of weaker-rated junk. And the graph below shows this even more clearly, as it compares the credit spreads on three categories of high yield bonds (BB, B and CCC) to the credit spread on the lowest investment grade rated category (BBB).
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Let’s put 2019 into perspective.
These tables again illustrate the relatively poor performance of CCC bonds this year, even though yields and spreads have narrowed marginally on an absolute basis. In fact, some contrarian investors see the CC high yield bonds as one of the few 2020 opportunities. But it also importantly shows that:
i) the yields on BB bonds (3.79%) now are nearly 100 bps tighter than yields on BBB bonds (4.71%) at the end of 2018,
ii) BB spreads now (1.95%) are exactly the same level as BBB spreads at the end of 2018, and
iii) within the IG universe, the yields on BBB bonds are now around 25bps tighter (3.23%) than yields on AAA bonds (3.55%) at the beginning of the year.
The Fed has primed the pump, and credit has had an amazing run this year across the spectrum, aside from CCC, and an investor would have made money whether in BBB, BB or B bonds from the beginning of the year.
So back to the headline of the OpEd in Bloomberg this morning – are yields on high yield bonds really reflecting their credit risk, when BB yields and B yields (spreads) are only 3.79% (+1.95%) and 5.60% (+3.76%), respectively, as we near year-end? Time will tell, but as the US economy continues its steady growth, I have yet to see a definitive sign of credit deterioration, albeit investors seem to be preparing for darker days by avoiding the weakest category of high yield bonds, CCC. Nevertheless, 2020 should bring plenty of new bond issuers across the credit spectrum, and investors really have little choice but to play along in order to try to meet their yield targets. It is in many respects the perfect storm, that is, until it is not!
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