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The Low Spark of High Yield Boys, Redux

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High yield is approaching levels where the principal protection risk/reward has been maximized.

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HY Vs. IG CDX Vs. S&P 500 Risk Premium



Prior to the 2008 financial crisis the 5Y-year HY CDX spread was priced at a 250bps cheap to the S&P risk premium (using 5-year Treasury yield) and as the crisis unfolded this spread blew out to over 1000bps. Since that peak in 2009, HY has generally outperformed with spread tightening through three basic stages with respect to equity risk premiums. The first stage between 2009 and 2010 saw HY spreads take back virtually the entire crisis-related steepening, eventually trading back on top of equity risk (see zero line). During the second stage between 2010 and 2012 HY and equities maintained this equal spread relationship with neither deviating more that ~100b on either side of the rich/cheap zero line. The third stage emerged in June 2012 as a notable divergence developed between the performance of HY credit risk and equity risk.

S&P 500 Risk Premium Vs. HY CDX



Between July 2011 and July 2012 inflation declined considerably with the PPI falling from 7.0% to nearly zero at 0.5% and the CPI falling from 3.4% to 1.4%. Over the same time the yield curve as represented by the 5-year/10-year spread had flattened by over 50bps. As inflation pressure subsided the inflation premiums in risk assets eased, and with that risk premiums tightened. HY has led the way with the HY CDX spread tightening from 700bps to 350bps; against equity risk, high yield outperformed from an even spread in June to over 200bps rich.

The casual market observer would look at the parabolic move in the S&P 500 and assume stocks have led the rally in risk, and from a price-percentage-gain perspective, they have outperformed HY bonds. However from a risk premium/multiple perspective HY has massively outperformed stocks, suggesting the rally in stocks is actually a function of multiple expansion on the back of HY credit risk premium tightening. This revelation has important consequences going forward because of where credit sits at this stage in the cycle both on a relative basis and in outright yield.
No positions in stocks mentioned.
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