The charts
A high proportion of the global high-yield market is currently trading at a tighter (more expensive) spread than other parts of the credit market which offer much higher credit quality.
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Global Investment Grade
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European A-rated CLOs
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Current coupon US Agency MBS
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Source: ICE BofA, Bloomberg, JP Morgan, Citi, 31 May 2024. The percentage is the proportion of outstanding debt within the ICE BofA Global High Yield index that trades at a tighter spread than the headline spread of the respective indices. We use swap OAS and discount margins for Global Investment Grade (IG) and CLOs respectively and compare against Global High Yield (HY) swap option-adjusted spread (OAS). We use the spread over a 5/10yr Treasury blend for Agency MBS and compare against Global HY Government OAS. Global IG and HY data are from the ICE BofA Global Corporate Index (G0BC) and Global High Yield Constrained Index (HW0C) respectively. CLO discount margins are from Citi, and Agency MBS spreads are from JP Morgan.
The context
Unsurprisingly, the tougher backdrop of higher-for-longer interest rates has resulted in stress (significant widening of spreads) in some of the lower-rated segments of the high-yield market. We have previously discussed how this was inflating headline index spreads to make the high-yield market appear more attractively valued than it really is. This distressed tail, in part, explains why many investors have been crowding in the higher quality segments of the high-yield market.
Darpan Harar, Portfolio Manager, Ninety One: “For the many investors in benchmark-relative high-yield strategies, the only place to turn to is the highest-rated area of the high-yield market, BB rated bonds. As a result, a widespread preference for quality has driven credit spreads in this part of the market to very expensive (tight) levels, particularly in relation to other – much higher quality – credit markets”.
As the charts show, nearly 10% of the global high-yield index is trading at tighter levels than the global investment grade index, and almost half of the index is tighter than European single-A rated CLOs. In both cases, these are close to decade highs. Perhaps most surprisingly, 18% of the global high-yield market has tighter spreads than those available on newly issued Agency mortgage-backed securities (MBS). Considering that Agency MBS are guaranteed by Government Sponsored Enterprises (GSEs) and are therefore deemed to have comparable credit risk to US Treasuries, this is particularly striking. However, it is also important to note that Agency MBS are trading at very elevated spread levels due to the US Federal Reserve reducing its MBS holdings, and the market pricing in high uncertainty around future mortgage prepayment rates.
The conclusion
Investors with benchmark-relative high-yield debt investments are paying a significant premium in their pursuit of quality. Higher quality assets can be found elsewhere in the global credit opportunity set and, perversely, these are now offering similar if not higher credit spreads. For instance, both the global investment grade market and European A rated CLOs have a rating that is significantly higher than the global high-yield index and are paying the same if not more spread than a material proportion of the global high-yield index.
Harar concludes: “The benefits of an unconstrained approach to credit investing, which allows much greater flexibility in how to achieve an increase in credit quality, has rarely been starker.”