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The Low Spark of High Yield Boys, Redux


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


S&P 500 Vs. HY CDX

With interest rates at the zero bound a rally in risk premiums/multiples is capped in price at some level. In other words with no more appreciation available in the reduction of benchmark interest rates, the only catalyst to a continued rise in the price of the risk asset is in risk premium compression. The problem is that with risk premiums already at historic tights on top of zero interest rates, the total rate of return provided by the credit is near what would be considered a minimum risk adjusted return on any investment, much less junk bonds. I think a good benchmark to work with now that interest rates are on the floor is the YoY growth rate in nominal GDP which essentially represents the US economy's ability to service its debt.

Spreads measured by the IG CDX have remained relatively stable since the crisis eased and yields have generally been a function of Treasuries which have traded below nominal GDP since taking out 4.0% in 2010. However IG companies by virtue of their investment-grade rating generally operate more liquid balance sheets and are therefore less sensitive to the growth rate in the economy in order to meet debt service. Investment grade credits yielding below nominal GDP are thus easier to justify for investors.

High yield credits, on the other hand, operate highly leveraged balance sheets, which are much more sensitive to economic growth. Typically you will see high yield spreads steepen when NGDP decelerates because of the increased cash flow risk, but since NGDP began to soften last year, these spreads have instead tightened. With high yield spreads contracting to new lows on top of falling benchmark yields to historic lows, the absolute yield on high yield credit is now approaching the level of nominal GDP.

If you assume that high yield will refrain from trading through nominal GDP with interest rates at the zero bound, we can put a maximum price on the HY CDX index which in turn we can use to put a maximum price on the S&P 500. Friday the markit CDX NA HY S20 index closed at a new all-time high of 106.69 at a spread of 352bps. Using the current 5-year swap rate of 90bps with the average nominal GDP level of 3.5% over the past two quarters we can price a minimum spread of 260bps (3.50%-0.90%) representing a 90bps tightening from today's 350bps level. At 260bps the HY CDX prices at 111.15 for a 4.2% price appreciation of 4.5 points. If you assume the equity/credit beta of 1.6x remains constant it implies a maximum 6.7% appreciation in equities to 1722 on the S&P 500.

On the surface one might look at the effect of tightening credit risk premiums as evidence that the Fed's QE portfolio balance channel is working just as planned. However aside from just looking at spread compression on its own, if you look at the actual behavior of investors there does not appear to be a material increase in allocation to risk assets at the expense of their holdings of risk-free Treasuries.
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