2022-09-08

Credit Risk is Bottoming

High yield bonds are becoming precariously priced.
Credit risk is getting compressed as bonds continue weakening. Either we're entering a new era where high yield credit leads the market (that's what a breakout on these charts would indicate) or high yield is at increasing risk of a "plug pull" moment should credit risk rise. Since bonds are falling, the risk inherent in high-yield bonds won't simply rise in step with credit risk, but will suddenly catch-down to the slide in treasuries.

The ex-dividend chart shows a consistent decline in high-yield credit. Unless there's an economic boom around the corner, these charts also paint a bearish picture. The relationship with TLT is interesting though. It makes sense that HYG would spike when TLT is low, but through this lens, we can see that the relationship is also stretched. Putting all the above charts together, I think its safe to say that in relative terms, credit risk is bottoming.

Credit spreads, including the investment grade spread:
These charts provide the final context. Credit risk is not only elevated, but it is approaching the sell everything line for the stock market. Yet in relative terms compared to a portfolio of government or corporate bonds, high-yield debt is reaching resistance. It has stealthily diverged because this cycle didn't include economic risk (yet). 

Bonus: here is the high-yield spread vs the ratio of IEI to HYG (inverse of above). It shows the gap I'm talking about. 



If I had to pick a "you are here" candle, it would be October 2018. A similar setup with a stock market decline, bonds falling, but the bond market starting to look for a pivot. HYG would lose about 6.5 percent into December. I suspect much larger losses are in the cards this time because the macro setup is an echo of 2008: rates are elevated, but credit risk will jump as interest rates fall in a recession. Conversely, if you forecast falling interest rates without any rising economic risk (Goldilocks returns), then perhaps the low for stocks is in and happy days are here again for bulls.

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