The Latest Bill Gross Trade: Shorting High-Yield Corporate Credit Spreads

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Includes: HYG, JNK, VWEAX, VWEHX
by: Joshua Hudson, CFA

Summary

Bill Gross was out touting his latest trade - shorting high-yield credit spreads.

This trade makes a lot of sense given high-yield spreads are near multi year lows.

High-yield corporate bonds have historically been positively correlated with oil, but that relationship has broken down as oil plummeted.

Will high-yield corporate bonds follow oil lower?

Bill Gross spoke about his latest trade in a Bloomberg interview yesterday and announced he is shorting high-yield credit spreads. According to the interview, he is using credit-default swap indexes to do this.

Understanding Spread

We don't have to deep dive into credit default swaps to understand this trade. Spread is simply the compensation a bond investor receives over the risk-free rate which in this case is the U.S. Treasury rate. If a 2 year treasury pays 1.3% and a 2 year high-yield corporate bond pays 3% then the spread is 1.7% (3% - 1.3%). Easy enough.

Spread is a measure of credit risk or the risk the issuer will default on a bond payment. Companies that are doing well benefit from lower spreads which means they can borrow at a lower rate. In times of distress, spreads increase and it becomes more costly to borrow.

This trade seems like a no brainer given how tight high-yield spreads have become. The chart below shows the average high-yield corporate spread at 3.76% which is approaching the lows of 2014 when spreads touched 3.5%

US High Yield Master II Option-Adjusted Spread Chart

US High Yield Master II Option-Adjusted Spread data by YCharts

Bill Gross correctly points out spreads don't have much more room to go lower so he is betting they will increase from here. That leads to another bond related risk measure: spread duration.

About Spread Duration

The most common measure of duration is known as Macaulay duration which measures the changes in a bond's price due to changes in interest rates.

Spread duration is completely different in that it measures the price change of a bond due to changes in spread.

If you are invested in high-yield funds that own an underlying portfolio of high-yield bonds, you should probably be aware of the spread duration of that portfolio.

Below is the spread duration for several high-yield funds, based on Bloomberg data:

iShares High Yield Corporate Bond ETF (NYSEARCA:HYG): 3.55

SPDR Bloomberg Barclays High Yield Bond ETF (NYSEARCA:JNK): 3.66

Vanguard High-Yield Corporate Fund (MUTF:VWEAX) (MUTF:VWEHX): 3.87

The spread duration provides an estimate of how much the portfolio would lose if spreads rose 1% across these portfolios. In the case of HYG, the fund would be expected to lose 3.55% if spreads increased 1%. Likewise, if spreads fell another 1% the portfolio would stand to gain around the same amount.

Take a glance at the spread chart I posted earlier and you will see how much wider spreads were at the beginning of 2016 when oil bottomed out. About 4.75% higher. With a spread duration of 3.55 to 3.87 the losses would be expected to be around 16-18% if spreads were to widen out that much again.

Speaking of oil...

High-Yield Little Changed on $45 Oil

Oil and high-yield have historically held a positive correlation but the past few days high-yield has all but ignored the sell-off in oil.

The chart below is the 1 year chart of HYG (white) and WTI Oil (red). Oil tends to be more volatile but the lines have generally followed fairly closely. Bloomberg calculates a positive correlation of .6 over the past two years.

I posted about this earlier in the week but it looks like high-yield has some catching up to do. Will oil test $44 and then $40 in the near future? The last time oil fell below $40 you can see what happened to high-yield spreads below. HYG and JNK have about 9% allocated to oil and gas.

US High Yield Master II Option-Adjusted Spread Chart

US High Yield Master II Option-Adjusted Spread data by YCharts

Conclusion

Bill Gross might have lost his title as "bond king" to Gundlach but he still provides valuable insight into fixed income markets. Most investors won't be taking bets on high-yield spreads through credit default swaps but reviewing high-yield exposure would make sense given the low spreads. If oil continues heading towards $40 I expect to see high-yield spreads widen.

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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.