Tuesday, February 06, 2007

U.S. Corporates: How tight are we really?

Serena Ng has a piece in today's Wall Street Journal titled Bond Boom's Thin Ice, which focuses on tightness in the high-yield bond market. Its conventional wisdom that corporate bonds in general are extremely tight, but take a look at the actual numbers and you might find they aren't as tight as you thought.

Here is a 10-year graph of corporate bond spreads using the OAS of the Merrill Lynch Corporate Master and Merrill Lynch High Yield Master.

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The high-yield spread is on the right axis and the investment grade spread is on the left axis. The dashed line represents the median spread. Some interesting points jump right out at you. First, if you correct for scaling, the high-yield and investment-grade spreads are very highly correlated, and the median spread is almost exactly in the same spot.

While both series are tighter than the median spread, the deviation between the median and current spread is much greater with high-yield. The investment grade spread is 19bps tighter than the median (88bps now vs. 107bps median). The high-yield spread is 167bps tighter than median (267bps vs. 434bps). The investment grade spread is currently in the 20th percentile while the high-yield spread is in the 11th percentile. We see that historically, high-yield spreads have been about 4x investment-grade spreads. Right now that figure is barely over 3x, and is the tightest ratio in this series.

So anyone trying to explain why credit spreads are tight needs to explain why high-yield has outperformed investment grade so severely. I don't think strong economics or more conservative balance sheets can explain it. First, there is a large contingent of investors who expect weaker economics in the next 1-2 years. And its almost universally assumed that shareholder friendly activity, such as LBO's and stock buybacks, will erode at least some of the balance sheet strength currently enjoyed.

I think the answer is new demand. The advent of CDS and rise of hedge funds as the dominant force in the corporate bond market are helping spreads. But hedge funds are merely a symptom of the real problem: too much liquidity. Blame the Fed, blame the ZIRP, blame China's over saving. Blame whatever you want. When too much liquidity is available, that cash has to go someplace. High-yield isn't the only place its winding up, but its perhaps one of the places regular investors are most likely to get hurt when the liquidity is finally squeezed out.


Vivek said...

Another reason why yield spreads are considered too tight, especially for high yield, is that the percentage of CCC bonds within the high yield market has increased greatly, but given low default rates that may be because rating agencies have become more strict.

I do think you're right about the cause being liquidity. There's an interesting song about the very thing:


Tom G. said...

I believe the high-grade index also has a higher percentage of Baa names as well, but give than the spread between A and Baa is a hell of a lot smaller than B-Caa, I don't think that corrects for the problem.

If we were going way back to the 1970's or something, that'd be a difference story.

Anonymous said...

Great note. Thanks.