The Low Spark of High Yield Boys, Redux
High yield is approaching levels where the principal protection risk/reward has been maximized.
The percentage you're paying is too high priced
while you're living beyond all your means.
And the man in the suit has just bought a new car
from the profit he's made on your dreams.
But today you just swear that the man was shot dead
by a gun that didn't make any noise.
But it wasn't the bullet that laid him to rest
was the low spark of high-heeled boys.
The Low Spark of High-Heeled Boys
-- Jim Capaldi and Steve Winwood, Traffic
Amid all the euphoria this week as US stocks broke out to new highs on weaker than expected economic data, the real story for me was the continued performance in the high yield credit market. The markit North American HY CDX Index closed at a new all-time high right alongside the S&P 500 (INDEXSP:.INX) pushing its implied spread to 352bps, a level not seen since 2007.
With little growth in earnings or revenues, the robust rally in equities has been a function of multiple expansion which is directly attributable to the massive tightening of high yield credit spreads. Contrary to previous cycles of spread tightening, this is occurring as yields on Treasuries also fall, suggesting this rally in risk is predicated not on what many assume in QE reflating assets, but rather the exact opposite in lower inflation premiums.
When the Fed balked at extending QE II when it was due to expire at the end of June 2011, it was a rude awakening for speculators who were very long an asset reflation correlation trade. However the Fed was in a box because it was this reflation of assets at the expense of the US dollar that was a drag on the consumer. In July 2011 the producer price inflation (PPI) was growing at a whopping 7.0% YoY rate with consumer prices (CPI) growing 3.5% in an economy that was only growing at about 4.0% nominally. In September, with stocks crashing alongside the QE reflation trade, the Fed needed to get back involved. They were well aware of the inflation pressures QE placed on the consumer, so instead of further balance sheet expansion, they opted for the balance-sheet-neutral Operation Twist. This is an important distinction.
You often hear equity strategists discuss valuation, citing the equity risk premium, which is the earnings yield (the inverse of the P/E ratio) measured as spread over the 10-year Treasury yield. The current equity risk premium of 4.6% remains on the cheap side of historical multiples however I think this relative value analysis is inherently flawed because multiples tend to be more sensitive to inflation rather than nominal interest rates.
"Real" Equity Risk Premium
I charted the difference between the S&P 500 earnings yield spread less the 10-year yield vs. the YoY growth in CPI. What you can see is that routinely the earnings yield would trade through the 10-year yield whereas rarely would it drop below inflation. In fact each major top in stocks over the past 30 years (1987, 2000, and 2007) were when the earnings yield met the inflation rate. This is completely rational because the market should only pay a multiple for real returns otherwise the monetary authority could always make risk assets look attractive by manufacturing nominal growth and negative interest rates.
Equity and credit risk premiums are closely correlated, and when plotted together you can get a sense of the risk curve. From the investor perspective, equity risk should always be cheaper than credit risk for where it sits in the capital structure, but in general, equity risk and high yield credit risk premiums have historically been priced at similar levels. High yield investors price credit risk to achieve an "equity-like" return while equity investors price earnings to provide a similar yield that also owns the option on earnings growth.
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.
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.
Flow of Funds Corporate Bond Assets
Of the major holders of corporate bonds it is the mutual fund accounts that have seen the most increase in corporate bond assets since 2008, however their share of Treasuries has also increased, presumably to meet the income demand from investors. Mutual fund flows also confirm this trend with taxable fixed income still receiving a vast majority of investor flow when compared to tax exempt or equities. According to ICI, in the past four weeks of the $27 billion in mutual fund flows, taxable bonds received $16.8 billion compared to a $1.3 billion and $81 million outflow of municipals and domestic equities respectively with the balance into foreign equities and hybrids.
The Fed isn't pushing investors into credit and equity risk by taking Treasury stock out of the market. This is a secular asset allocation shift by an aging population predicated on principal protection and the demand for income. This environment of falling inflation amidst this demand for yield is driving a reduction in the inflation premium embedded in the risk multiple which is manifesting in overall lower risk premiums.
Clearly high yield is leading this rally in risk but presumably we are in the late stages of this multiple compression as high yield approaches levels where the principal protection risk/reward has been maximized. This implied price cap not only raises the risk of investing in high yield but also other risk assets such as stocks that have been riding the coattails of risk premium compression.
In February of 2008 I wrote an article that was published on Safehaven titled the Low Spark of High-Yield Boys.The idea was that the falling Treasury yields were in danger of taking out the previous 2003 low at 3.35% and if so were signaling a much different economic reality than the market was prepared for and proof that the credit leveraging cycle had had turned.
... Therefore, if yields get down to previous lows and actually continue lower while flattening the curve it will suggest the market and economy are in much worse shape and in need of a much lower cost of capital to generate positive returns. That equals a long term low return environment for all assets.
Today I get the same feeling that economic reality is about to trump the thirst for yield at any price. For high yield credit to trade rich to the growth rate of nominal GDP would truly be beyond the scope of even the most egregious financial irrationality. Price still matters at some level, and the closer risk yields get to the growth rate in the economy, the lower the margin for error when economic growth affects future cash flow those yields represent.