July 23, 2020: Corporate Credit Sector Relative Value YTD and since peak of Covid
Chart 1: the relative BBB sector spread histories YTD relative to BBB all corporates average.
- Every significant relative gainer or loser reverted post peak of the crisis. This indicates that each significant sector deviation relative to the average of all corporates was an over-reaction.
Chart 2: relative value spread pick-up for long/short pairs for the period YTD
- The best sector trades YTD were long Healthcare or IT/ short Real Estate, Insurance or Energy.
Chart 3: relative value spread pick-up for long/short pairs for the period since the Covid related credit crisis peak 25-Mar-2020
- The best sector trades since peak of crisis were long Energy/ short Real Estate or Insurance; or long Consumer Discretionary/ short Insurance.
- Most sectors maintained their relative value despite over-reacting initially.
- Insurance and Real Estate are the exception: their story flipped from relative positive at the peak to relative negative since the peak.
All charts are based on USD 5Yr constant maturity credit spreads of North American corporates.
July 13, 2020: Fixed Income Styles: Something New for 2020
Factor investing has long been a staple of quantitative equity portfolio management and has generated a great deal of interest on the Fixed Income side in recent years. With the introduction of the Axioma Factor-based Fixed Income Risk Model, estimated through cross-section regression of issuer spread returns, we can study the properties of fixed income style factors such as Momentum, Value, Size and Beta to the market. And something interesting has happened during the COVID crisis:
- Using monthly overlapping returns going back to 2002, we can estimate style factor volatility with an EWMA estimator with 1 year half-life and 4 year look-back. We compare both Fixed Income and Equity style factor volatilities computed under these settings. We use the Fixed Income covariance settings for the Equity model for ease of comparison; it should be noted that, for this reason, the equity factor volatility computed here differs from what is published in the Axioma World-Wide Equity Risk Factor Model, although the factor returns are the same.
- Throughout this history, the Beta factor for both FI and Equity generally has had the largest volatility of all the style factors. The FI Beta vol has been fairly stable since 2007, fluctuating between 5% and 7.5%, while the Equity Beta vol has been mostly between 3% and 5% except for a period starting with the Global Financial Crisis.
- Until March 2020 and COVID, that its, as can be seen in the chart. Suddenly Beta volatility shoots up. For Equity Beta vol, it’s back to GFC levels of 7%. But for FI Beta, this is something new and extraordinary, spiking up to over 19%. The other FI and Equity style factor vols also increase, most notably Size, but not to levels different from the GFC.
- The impact of the new regime in Fixed Income Beta behavior has been explored in the blogpost “Corporate Credit Portfolio Construction: Targeting low-beta names during the COVID-19 Market Crisis”.
July 6, 2020 Regime Change for Credit Spreads
For STOXX USA 500 companies that issue bonds, the first half of 2020 looked remarkably different that the second half of 2019 through the lens of credit spread changes.
- H1 2020: Almost every name saw its issuer spread widen from January through June. Due to the COVID crisis equity returns skewed negative, but there were still plenty of big winners like Apple and T-Mobile.
- H2 2019: Almost every name saw its issuer spread tighten from July through December. Equity returns skewed positive, but covered a range of gains and losses, with equity volatility relatively constant for most names.
- Theory 1: The market has repriced credit risk across the board, demanding higher spreads for all names, even those with high performing equity and lower default risk. The new regime has a higher market price of credit risk.
- Theory 2: There is a new regime in equity market volatility – 66% of the names in the index saw their June 2020 equity volatility more than double compared to their December 2019 volatility, and 31% more than tripled. In a Merton model framework, even massive equity returns may not be sufficient in light of the volatility increase to keep default risk from increasing and spreads widening.
- Charts: The pictures tell the story, plotting credit spread change vs equity return for the two periods. The color of the points indicates investment grade or high yield, while for the H1 2020 chart, the size of the points indicates the scale of the volatility change. Not surprisingly, airlines and cruise ships take the biggest hit across the board of equity, credit and volatility. But many equity winners also had significant volatility increases, consistent with credit spread widening. However, names like Netflix, with a 44% period equity return, no change in equity volatility, yet a 100 bp spread widening, suggest credit risk commands a higher premium in June than it did in January.
June 29, 2020: Leverage vs credit spreads: No extra support from the Fed
- Corporate bond purchases by the Federal Reserve have led to both lower credit-risk premia and higher share prices, but leveraged companies have benefitted to only a limited degree so far.
- In some previous crisis—such as the bursting of the dotcom bubble and the Eurozone debt crisis—companies with a larger debt burden did benefit disproportionally from lower borrowing costs. But they did not recover to the same extent in the global financial crisis and the current environment.
- Although Leverage is not considered a “rewarded” factor—and would thus normally be expected to revert toward its mean—it seems to exhibit significant downside risk in times of severe credit crises. And quantitative easing is not guaranteed to provide any extra support.
- For more detailed information, see our recent blog post on how Fed bond purchases do little for leveraged firms.
June 22, 2020: Eurozone sovereign spreads: it’s different this time
- Peripheral Eurozone issuers, such as Italy and Spain, saw their risk premia over German Bunds increase in the light of the extensive fiscal rescue packages required to deal with the fallout of the COVID-19 crisis
- But large-scale central-bank buying meant that spreads widened much less than in the Eurozone debt crisis of 2011-12 or during the Italian government-deficit conflict in 2018
- Yield premia on Spanish Bonos rose significantly less in the current environment, reflecting a much stronger fiscal position both compared with the Eurozone debt crisis and relative to its Mediterranean neighbour
June 15, 2020: The Corporate Credit Illusion of a Free Lunch
- BBB-rated corporate bonds yield more than AAA-rated ones to compensate for their lower credit quality.
- Within the Investment Grade spectrum from AAA down to BBB one would expect the volatility of credit spreads to go from lower to higher in order to adjust for increasing yields.
- Instead, outside of crisis periods, the volatility of credit spreads is roughly the same from AAA down to BBB. This pattern can be observed for USD, EUR, GBP. Beware: Mean-variance optimization, Information and Sharpe Ratios all rely on volatility! (More on how we can address this in Risk measurement and modelling in times of crisis).
- Is this a “free lunch”? No! Volatility does not capture other risks such the “Falling Angel”, the company’s risk of downgrade leading to loss of its cherished Investment Grade status and dropping out of the index. Read more on this in our recent blog, Is BB the new BBB?.
- Buckle your belt and use your mouse to navigate the 3D volatility landscape in this week’s fixed income chart. Check for yourself: only during major crises (GFC in 2009 and COVID in 2020) does the volatility show any significant differences in the AAA-BBB range, but not during other periods.
Source: Qontigo, Axioma Fixed Income Spread Curves.
June 8, 2020: CDS: Examining the Negative Basis
- The average 5y CDS basis, that is, the 5y CDS level minus the level of the 5y point on the bond curve, is in a significantly negative territory, which is unusual.
- This chart shows the basis for names in the Markit iTraxx Europe index; the same observations can be made for the CDX investment grade index in the US.
- Initially, both bonds and CDS widened. In a crisis that is expected to be short-lived, buying protection makes sense, and we believe this is what banks and hedge funds did. Real money funds may still have needed to sell bonds.
- It was only after this that the basis widened. After the initial panic, we believe some of the index hedges would have been closed out, but there hasn’t been a rush back into corporate bonds. CDS are leading bonds tighter.
Source: Qontigo, Markit
June 1, 2020: U.S Mortgages: Low Rates and High Risk
- US mortgage and treasuries rates are at historic lows following the market’s reaction to the COVID-19 crisis and the Federal Reserve’s action to address this.
- However, the spread between the 30-year fixed agency mortgage rate and the 10-year constant maturity treasury rate is close to its highest level since the mid-1980s, surpassed only by the spread at the end of 2008 during the Global Financial Crisis, and 80 bp higher than a year ago.
- While equities and corporate credit spreads have substantially recovered since their extremes in mid-March, high mortgage spreads have persisted through the end of May, with a period of 10 weeks over 250 bp.
- Although the agency mortgages are implicitly guaranteed against default, great uncertainty exists around the impact of the crisis on prepayments driven by delinquencies, refinancings, and relocations.
- Historic unemployment, massive additional government spending, Fed asset purchases, and an uncertain housing market have produced historically low mortgage rates and rarely seen mortgage-treasury spreads.
Freddie Mac, 30-Year Fixed Rate Mortgage Average in the United States [MORTGAGE30US], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/MORTGAGE30US, May 27, 2020.
Board of Governors of the Federal Reserve System (US), 10-Year Treasury Constant Maturity Rate [DGS10], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/DGS10, May 29, 2020.
May 25, 2020: Credit Spreads: A Tale of Two Sectors
- Corporate spreads have widened across the board since the start of the COVID 19 crisis.
- Not surprisingly, some sectors have been hit harder than others.
- Through the lens of the Axioma Factor-based Fixed Income Risk Model, the implied spreads of the USD Consumer Discretionary sector have widened substantially more than those of the USD Healthcare sector – with close to a 500 bp difference for the riskiest spread quartile.
- The results suggest outperformance over this period of portfolios constructed with the Risk Model to track a benchmark with a tilt toward Healthcare and away from Consumer Discretionary.
...It was the best of sectors, it was the worst of sectors.
May 18, 2020: Bank funding risk returns to normal after a brief spike
- The 3Month LIBOR-OIS spread has come back as rapidly as it widened.
- It is a measure of bank credit risk and liquidity of lending.
- The COVID-19 related widening was the largest since the Global Financial Crisis, but reached only half those levels.
- The spread is back to pre-COVID levels.