One of the key features of the recent episode is that the ~$10.5 trillion in global central bank liquidity has kept the bond term premia and credit spreads much more contained than in previous crises (relative to the GDP shock). Indeed, following the recent compression in high yield spreads, credit risk compensation in the US high yield market is back to pre-2020 crisis levels and within 100 basis points of the record low in 2005. Given the record low in Treasury yields, the outright yield-to-worst on the US high yield index has also compressed to a record low. The Junk bond absolute yield is now trading below 4% or at the lowest level in history (chart 1). The yield is no longer “high” in high yield. There are a few key points to note.
First, as has been widely observed, the 2020 recession contributed to a once-in-a-century contraction in the economy and profits. However, the speed, size and scope of the policy response was also the earliest, broadest and biggest in history. The US Federal Reserve balance sheet alone increased by more than $3.2 trillion or 80% year-on-year (chart 2). The Fed also cut policy rates, anchored future short rate expectations, provided direct support to the credit markets and modified their inflation target to permit the economy to run hot or above 2% inflation for a period. For markets, the policy response was clearly very successful in compressing risk premia relative to the GDP shock or the contraction in profits.
Second, the compression in credit risk premia has been greater than the decline in equity market volatility since the 2020 March low (chart 3). As we have often noted, there is an intimate link between liquidity, volatility and leverage. The irony is that in a “value-at-risk” framework, investors can take more “risk” and leverage when volatility is low or compressed. Perversely that is precisely when potential risk is greatest following a build-up in investor and corporate leverage. These regimes also coincide with phases when interest rates are low and central bank liquidity is plentiful. Stated differently, there is a pro-cyclical or reflexive self-reinforcing virtuous circle between the impact of increased liquidity on risk premia/perceptions, asset volatility and leverage. However, it is interesting that credit risk premia, bond volatility and FX volatility has narrowed considerably more than the compression in equity volatility. Of course, it might be that the mean reversion or convergence in this case will occur through further compression or selling of equity volatility before the rally in equity prices is over.
The good news is that it seems unlikely that the Federal Reserve will prematurely withdraw liquidity while their stated inflation target – the core PCE – remains well below 2%. Given equity risk premia (and equity volatility) remains elevated relative to fixed income there is likely decent odds in further upside in equity markets. In the high yield market we also see relative value or decent risk compensation in Asia. The Asian high yield index trades 330 basis points wider than US high yield (chart 4). That is wide in a historical context over the past decade and given comparable credit quality. One caveat from a regional perspective is that the PBOC has started to moderate lending to the real estate sector in China (a key component of Asian high yield). That moderation in credit is also evident in the slow down in China’s credit impulse.
In conclusion, high yield spread compression is likely to continue while Fed liquidity remains plentiful. However, in relative terms there is greater value in Asia Pacific equity and Asian high yield. The big picture point is that high yield has limited upside but considerable downside if credit spreads widen or less attractive asymmetry. A long position in high yield is also effectively short volatility and tends to be most vulnerable after a build up in leverage.
About the Author:
Nick Ferres is CIO of Vantage Point Asset Management. Prior to this, Nicholas was at Eastspring Investments, the Asian asset management business of Prudential plc, as Investment Director, in September 2007. Nicholas was Head of the Multi Asset Solutions team and was responsible for managing the global tactical asset allocation of funds for external institutional and retail clients. Before joining Eastspring Investments, Nicholas worked for Goldman Sachs Asset Management as Investment Strategist & Portfolio Manager. He has more than 20 years of financial industry experience. Nicholas holds a B.A. (Hons) in Economic History and Politics from Monash University, Australia, a Graduate Diploma in Economics and a Graduate Diploma in Applied Finance.