Corporate bonds have enjoyed a relentless bullish market since early 2016, with both high yield and investment grade spreads narrowing to their lowest levels in the last 10-years. This urges investors to rethink their ultra-positive stance on corporate credit. The risk-reward profile of corporate bond spreads is not as alluring as it once was. A synthetic long position on US Treasuries (NTSEARCA:TLT) coupled with short positions on investment grade (NYSEARCA:LQD) and high-yield bonds (NYSEARCA:HYG) seems a smart-play against the challenging macro environment and the rich valuations of corporate credit. More importantly, though, this strategy, which bets on the widening of corporate bond spreads over US Treasuries, could outperform irrespective of which macroeconomic scenario prevails down the line; a strengthening of reflationary growth or a downturn of the global business cycle.
Corporate Bond Spreads Are Too Expensive
Corporate bond spreads, i.e. the gap between the yields of corporate bonds and US Treasuries, are almost as narrow as they can be. This means that investors currently get the least compensation against the risk of corporate default. Were the economy to turn sour and default rates to rise, spreads would skyrocket. On the other hand, were the global business cycle to accelerate there would be only a limited potential for spreads to tighten further from here. In this case, a new big up leg in government bond yields would unfold pushing corporate yields upwards too. In fact, there would be too little room left for spreads to shrink and absorb the rise in benchmark yields. More importantly, though, as the economic cycle would be approaching its peak, investors would have no way to gauge when exactly to unload their corporate credit holdings before the spreads begin to widen again. Typically corporate spreads start inflating near the peak of the business cycle, long before a recession materializes. Such a spread widening coupled with a generalized increase in Treasury yields would definitely produce some big capital losses on corporate bond holdings, since bond prices move inversely to their yields.
There are two main corporate bond segments, investment grade and high yield, both of which seem to be expensively priced relative to US Treasuries. The BofA Merrill Lynch Index of US investment grade corporate spreads fell to 128 basis points over US Treasuries in early February. The average investment grade spread in the last four years or so before the eruption of the Great Financial Crisis (GFC), one of the most prosperous periods in modern economic history, was about 95 basis points. On the other hand this spread went over 260 basis points in late 2011, and touched 220 basis points in February of 2016, let alone the rise over 650 basis points during the GFC. Overall, the average investment grade spread over the last 10-years has been 200+ basis points.
Source: Fed of St. Louis
These facts suggest an apparent asymmetry here, since investment grade spreads can theoretically narrow another 30 basis points or so before reaching their best valuation ever, versus a spike of at least 100 basis points or more in case of a deceleration of the business cycle. This should not exclude the possibility of a rise of 200 basis points or more if the global economy slips to a recession. In simple terms, there is a risk of 200 basis points against a reward of 30 basis points or so, a more than 6 to 1 relationship.
However, the risk/reward profile of corporate bonds deteriorates if we take a look at the high yield segment of the market. The BofA Merrill Lynch High Yield Spread index hovers around 390 basis points over US Treasuries. This compares with the 280 basis points averaged for the last twelve months before the onset of the GFC. On the other hand, though, the spread easily climbed over 800 basis points both in late 2011 and in early 2016, before going down again. During the GFC the spread surpassed the 2000 basis points producing catastrophic capital losses for investors! This shows that US high yield spreads currently sit less than 100 basis points close to their all-time lows and more than 400 basis points from their intermediate highs. The inherent risk in high yield bonds is approximately four times the potential reward, without taking into account the highs of the GFC period. In the latter case the upside to downside ratio of the spread could easily turn into a 16 to 1 relationship. That is, the risk from a major global crisis amounts to sixteen times the projected gain under the most sanguine macro scenario; such a disastrous risk/reward profile!
Source: Fed of St. Louis
These historically tight corporate spreads open up a window of opportunity for a strategy involving the pairing of a long position on US Treasury bonds with a short position on investment grade as well as high yield bonds. This strategy can be executed by firstly opening a long position on TLT, which has an effective duration of 17.34 years. This means that a rise of 1% (equal to 100 basis points) in Treasury bond yields should be expected to cause a 17.34% drop in TLT prices.
This long TLT position must then be paired with two short positions on investment grade and high yield bonds with the same combined effective duration. The effective duration of LQD, the investment grade ETF, is 8.23 years while that of HYG, the high yield ETF, is 3.84 years. This means that in order to achieve a corporate bond positioning which gives the same sensitivity in bond prices under a 1% change in yields with the long TLT position, we need to build a short LQD position equal to the size of the TLT position and a short LQD position double the size of the TLT position. In other words, if TLT position is equal to one US dollar, then this must be matched with a short LQD position of one dollar and a short HYG position of two dollars. A 1% rise in all yields, i.e. if corporate spreads of every credit quality remain unchanged, will produce a loss of approximately 17+ cents from the TLT position, a gain of 8+ cents from the LQD position, and another gain of approximately 8 cents from the HYG position. The gains stemming from the short corporate bond positions will balance out the loss coming from the long position in US Treasuries, resulting in a neutral investment outcome. This neutral outcome shows that the strategy performs according to where the corporate spreads are headed, independently of where the Treasury yields are trending.
Should, now, US Treasury yields fall by 1% and credit spreads increase by 2%, the strategy will result in a net profit. A drop of 1% in Treasury yields will push corporate yields up by 1%, since their difference must now increase by 2%. This means that this drop of Treasury yields will produce a gain of 17+ cents on the long TLT position as well as another 16+ cents of gains collectively from the short LQD and HYG positions. An overall gross gain of 33+ cents comes as a result. This gain should be compared against a nominal long position of one dollar on US Treasuries coupled with a nominal short position of 3 dollars on corporate bonds. The higher the credit spreads go under this scenario, of course, the higher the gains from the short positions on LQD and HYG become, adding up to the total trade performance.
Either the new bond bear market will ultimately resume into a new strong up leg under the reflationary growth cycle, or bond yields will collapse ahead of a new global recession. In either case it seems that corporate bond spreads will sooner or later inflate and produce massive losses for their holders. A synthetic trade of long US Treasuries versus short US corporate bonds seems well suited to benefit in both cases. If the extension of the new bear market in government bonds prevails, the trade will take some more time to produce returns, since it will require the spreads to widen first. If on the other hand the global business cycle slips to a recession, corporate bond spreads will skyrocket producing some decent gains on the short side of the synthetic trade immediately. Whatever the case, investors are presented with a smart-play in the egregiously priced corporate bond market, releasing them from the need to time the reversal of the bond bear market or the global business cycle itself.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The views expressed in this article are solely those of the author, provided for informative purposes only and in no case constitute investment advice.