March 31, 2020

Crisis Period Entry Points

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David Jackson, CFA
Sr. Portfolio Manager

Credit spreads peaked at 10.87% so far in the COVID-19 crisis. Spreads above 10% have occurred in 16 months over the last 25 years. In those 16 periods, high yield bonds have outperformed other asset classes, even stocks, over the 3 years that followed. Crisis periods are never hoped for, and thankfully do not occur often. But they have shown to exhibit entry points with outsized return potential for tactical, disciplined investors.

There have been 7 major crisis periods in the last 25 years, including COVID-19. Thankfully, they are somewhat rare. While each crisis has differed in causality and market impact, they share 3 key features we will highlight today:

​​​​​     1) Elevated credit spreads (Exhibit 1): a measure of market credit risk, elevated above 7% ​​​​​
     2) Entry-point potential (Exhibits 2 and 3): outsized forward return at elevated spreads
     3) Asset class variation (Exhibits 2 and 3): return potential varies significantly by asset class


High Yield Bond Spreads, Returns, and Crisis Periods (Exhibit 1)
​​​​​ICE BofA High Yield OAS Index - Inception Dec 1996 to Mar 2020
​​​​​​Credit Spreads and Crisis Periods
As of 3/31/2020. Source: Bloomberg. Data is on a daily basis. Crisis period: defined as spreads elevated above 7%, downside return measured from ICE BofA HY index peak to trough. ICE BofA High Yield Option Adjusted Spread: yield of high yield bonds above their maturity-equivalent treasuries, adjusted for options. They are a measure of market credit risk. Current spreads and other relevant fundamentals can be found here.


Forward returns vary widely based on credit spreads at entry and asset class, as shown in Exhibit 2. Tactical investors seeking opportunistic entry points should note that high yield credit and small cap stocks exhibit the highest outperformance potential at elevated spreads. For long-term, strategic investors, it’s less of a priority. The ICE BofA High Yield Bond index has outperformed both the S&P 500 and Barclays Aggregate Bond indices over the last 20 years (12/31/1999 – 12/31/2019), so we are by no means suggesting a high yield investor must time the market.


Spreads and Avg 3-Yr Forward Ann. Return by Asset Class (Exhibit 2A)
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Source: Bloomberg. Data from 12/31/1996 to 3/31/2020. Indices: Russell 2000, S&P 500, ICE BofA High Yield, ICE BofA BB-B 1-3Y, S&P/LSTA Loan, ICE BofA Corp, ICE BofA Muni, BbgBarc Agg, ICE BofA MBS, ICE BofA Agency, ICE BofA Treasury. Past performance is no guarantee of future results.


Spread Distribution and High Yield vs Agg Bond Forward Return (Exhibit 2B)
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Source: Bloomberg. Data from 12/31/1996 to 3/31/2020. Indices: ICE BofA High Yield, BbgBarc Agg. Past performance is no guarantee of future results.


Credit spreads at 10% are especially rare, historically occurring during or near recession periods. Spreads reached a peak of 10.87% so far within the COVID-19 crisis. Historic periods at or above 10%, and their forward returns, can be found in Exhibit 3.


Credit spreads ≥10%: 3-Year Forward Annualized Return (Exhibit 3A)
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Source: Bloomberg. Data from 12/31/1996 to 3/31/2020. Indices: Russell 2000, S&P 500, ICE BofA High Yield, ICE BofA BB-B 1-3Y, S&P/LSTA Loan, ICE BofA Corp, ICE BofA Muni, BbgBarc Agg, ICE BofA MBS, ICE BofA Agency, ICE BofA Treasury. Past performance is no guarantee of future results.


Credit spreads ≥10%: Average 3-Year Forward Cumulative Return (Exhibit 3B)
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Source: Bloomberg. Data from 12/31/1996 to 3/31/2020. Indices: Russell 2000, S&P 500, ICE BofA High Yield, ICE BofA BB-B 1-3Y, S&P/LSTA Loan, ICE BofA Corp, ICE BofA Muni, BbgBarc Agg, ICE BofA MBS, ICE BofA Agency, ICE BofA Treasury. Past performance is no guarantee of future results.


In conclusion, tactical investors should monitor spreads closely as indicators of current credit risk and forward return potential. Riskier assets such as high yield credit and stocks have historically exhibited outsized returns when spreads were elevated at investment point of entry. When spreads have reached 10%, as they have in the COVID-19 crisis, high yield bonds have historically returned 18.6% on a 3-year forward annualized basis on average, with a minimum of 11.8%.


COVID-19 Crisis: Year to Date Credit Spreads (Exhibit 4A)
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Source: Bloomberg. Data from 12/31/2019 to 3/31/2020.


COVID-19 Crisis: Credit Fundamentals (Exhibit 4B)
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Source: Bloomberg. As of 3/31/2020. Indices: ICE BofA High Yield, ICE BofA BB-B 1-3Y, S&P/LSTA Loan, ICE BofA Corp, ICE BofA Muni, BbgBarc Agg, ICE BofA MBS, ICE BofA Agency, ICE BofA Treasury. Past performance is no guarantee of future results.


A PDF Version can be found here.

 


 

 

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