Would You Credit It? Canadian High Yield And The Anomaly With Investment-Grade Credit

Summary

• Credit markets extended April's rally in May, with spreads narrowing further versus government bonds.
• This was driven by renewed risk appetite, and central bank QE programs.
• Bank of Canada's QE program has helped tighten Canadian short dated IG spreads since its announcement, which exceeds tightening in 7-10 yr IG spreads.
• But there is notable divergence in performance of Canadian IG and HY spreads in 2020 when compared with performance of spreads in 2015/16.

By Robin Marshall, director, fixed income research

Risk rally and QE have driven in short-dated Canadian investment grade spreads relative to 7-10 yrs….

Credit markets extended April's rally in May, with spreads narrowing further versus government bonds. This was driven by renewed risk appetite, and central bank QE programs. The Bank of Canada's QE program, announced on March 27, is restricted to investment grade (IG) corporates only, and maturities of five years or less. The chart below suggests the program has helped tighten Canadian short dated IG spreads since the announcement, which exceeds the tightening in 7-10 yr IG spreads.

Canada credit spreads: 1-3yr and 7-10yr

Source: FTSE Russell. Data as of May 31, 2020. Past performance is no guarantee to future results. Please see the end for important disclosures.

…but Canadian high yield spreads & yields are below 2015/16 peaks, despite not being in QE

But there is a notable divergence in the performance of Canadian investment grade and high yield (HY) spreads in 2020 when compared with the performance of spreads in 2015/16 after the Canadian downturn and collapse in commodity prices. The following chart shows both high-yield spreads-and outright yields-were much higher in 2015/16 than 2020, even before the announcement of the BoC's QE program.

Further, Canadian high yield, or sub-investment grade spreads, have narrowed sharply since the BoC announced its QE program on March 27, despite HY credit not being included within the BoC's QE program. In contrast to HY credit, Canadian IG spreads are still close to the 2015/16 highs, and were well above those highs before the BoC announced the QE purchase program.

Canadian high yield (HY) and investment grade (IG) credit spreads

Source: FTSE Russell. Data as of May 31, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

This is odd, given the scale of recessions now underway

This seems odd, given the scale of the COVID-19 shock and deep recessions now underway, which far exceeds the mild Canadian contraction of 2015, which was concentrated in the energy sector, and not broadly based. Indeed, the BoC stated a further 10-20 percent deterioration in Canadian real GDP is likely in the second quarter 2020, in its press release on June 3, and the Federal Reserve Bank of Atlanta is projecting an enormous contraction of 51% in the US economy in Q2.

There is also a contrast with the US, since high-yield spreads and outright yields reached levels beyond the 2016 highs, in March 2020, before the Fed announced its QE, which also include high-yield credit (announced on April 9).

Index weight changes help explain some of the Canadian credit conundrum…

There are some possible explanations. Firstly, index weighting effects help to explain the relative movement in spreads between the two indexes. In 2016, the biggest credit-spread widening occurred in sectors in which the FTSE Canada High Yield Bond Index (HY) had much higher weights than the FTSE Canada Corporate Bond Index (IG); notably energy, industrials and communication. For example, in 2016, the HY index had a weighting of 26% in energy, compared to only 15% in the IG index, whereas now the index weights are 28% and 22% respectively. In contrast, financial spreads widened much less in 2016, in which the IG index had a far higher weighting than HY. This is shown in the chart below.

Canadian IG credit sector spreads since 2015

Source: FTSE Russell. Data as of May 31, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

Second, the expectation of HY credits being added to the BoC's QE purchase program might be a factor in Canada, restricting spread widening. Third, credit defaults in 2016/17 never reached the levels implied by spreads, so there may be some reluctance to push spreads out as wide as then. Fourth, previous experiences of HY spreads spiking above 800-850bp have often been followed by a period of strong returns in HY-in more normal cycles-as the spike unwound, so investors may have been attracted by the yield spreads. Finally, it is less likely that the average term, or duration, of the FTSE Canada High Yield Bond and FTSE Canada Corporate Bond indexes has been a factor since they have changed little since 2016. The HY index had an average term of 5.24 at on May 29, 2020 and the IG index an average term of 9.62. These compare with 5.15 for HY and 9.08 for IG in 2016.

…but outright yields are low in the HY sector for the depth, and breadth of recession underway

These factors may help explain relative credit spread index differences between 2016 and 2020, but they leave the puzzle as to why outright yields in sub-investment grade are still lower in 2020 than in 2016, given the depth of the recession, doubts about the trajectory of recovery, and higher default risks? Absolute yields are shown in the chart below, which suggest Canadian high yield credits may now represent a value trap, versus the more conservatively valued investment grade sector.

Corporate bond and 7-10 government yields since 2015

Source: FTSE Russell. Data as of May 31, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.

© 2020 London Stock Exchange Group plc and its applicable group undertakings (the "LSE Group"). The LSE Group includes (1) FTSE International Limited ("FTSE"), (2) Frank Russell Company ("Russell"), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, "FTSE Canada"), (4) MTSNext Limited ("MTSNext"), (5) Mergent, Inc. ("Mergent"), (6) FTSE Fixed Income LLC ("FTSE FI"), (7) The Yield Book Inc ("YB") and (8) Beyond Ratings S.A.S. ("BR"). All rights reserved.

FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and BR. "FTSE®", "Russell®", "FTSE Russell®", "MTS®", "FTSE4Good®", "ICB®", "Mergent®", "The Yield Book®", "Beyond Ratings®" and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, FTSE Canada, Mergent, FTSE FI, YB or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.

All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of FTSE Russell products, including but not limited to indexes, data and analytics, or the fitness or suitability of the FTSE Russell products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell products is provided for information purposes only and is not a reliable indicator of future performance.

No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.

No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing contained in this document or accessible through FTSE Russell Indexes, including statistical data and industry reports, should be taken as constituting financial or investment advice or a financial promotion.

Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.

This publication may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.

No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and/or their respective licensors.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.