A special thank you to Brett Freeze from Global technical analysis for its analytical accuracy and technical expertise.
There is a
old story about a little boy who was so extremely optimistic that he was worried
Parents took him to a psychiatrist. The doctor decided to mitigate that
Boy’s optimism by leading him to a room full of horse manure. Immediately
The boy waded enthusiastically into the middle of the room and said, “I know
Here is a pony somewhere! “
is with markets these days.
We often hear that the financial markets in “Everything
Bubble. “Stocks are overvalued, trillions in sovereign debt trading are negative
Interest rates, corporate loans, both investment grade and high yields seem to be
Trading with far more risk than return and so on. As investors, however, we have to
Ask, can we dig through this dirt and find the pony in the room.
In this discussion, it is worth considering the risk contrast between several
Credit market categories. According to the Bloomberg-Barclays aggregate
Investment grade corporate index, returns were at the end of January 2020
at 2.55% and in a range between 2.10% for Double-A (AA) loans
and 2.85% for Triple-B (BBB) loans. That means that the yield “moves”
A decrease in credit from AA to BBB is only worth 0.75%. When you put out a million dollars
from AA and BBB, you should expect to receive an additional $ 7,500 a year as
Compensation for significantly more risk. It only seems to gain 0.75%
poor compared to historical spreads, but in a world of microscopic returns,
Investors are desperate for income and willing to forego risk management and
As if the poor
Risk premium to own BBB over AA is not enough, you have to take into account that there is
an unusually high concentration of BBB bonds currently pending as a
Percentage of the total amount of bonds in the investment grade universe. The
Graphic below from our article, The enterprise
Maginot Lineshows how BBB bonds became a larger part of the
Universe for corporate bonds compared to all other credit levels.
We have discussed articles and highlighted how more ties than ever in history
The corporate credit markets are only one step away from losing their investment grade rating
As shared in the article and shown below, there is evidence that many of them
Companies are not even worthy of the BBB rating because of their debt ratios
Incompatible with investment grade categories. That is also worrying.
A second and
The factor often overlooked in risk assessment is the price risk embedded in it
Tie up. Interest rate risk is typically assessed on the bond markets
with a calculation called duration. Similar to beta in stocks, duration allows one
Investors estimate how a change in interest rates affects the price of
the connection. Simply, if interest rates would increase by 100 basis points (1.00%), duration
enables us to quantify the impact on the price of a bond. How much money would be
lost? After all, that’s what defines risk.
The duration risk on the corporate credit market is higher than at any time in at
at least the past 30 years. With an average term of 8.05 years for the
In the investment grade bond market, a rate hike of 1.00% would coincide
with the price of a bond with a term of 8.05 fall by 8.05%. In this case
A bond at face value (price of 100) would drop to 91.95.
Unit of duration
Metrics, yield and duration bring us to an important measure of value and a
Tool to compare different fixed income securities and classes, Combination of the two measures and
The calculation of the yield per permanent unit offers unique insights.
The measurement measures in particular how much return an investor receives (return)
in relation to the duration (risk). This ratio is similar to the Sharpe
Ratio for shares, but forward-looking, not backward-looking.
In the event of
of the entire investment grade corporate bond market as described above
Dividing the yield of 2.55% by the duration of 8.05 gives a ratio of 0.317. Put another one
In this way, an investor receives a return of 31.7 basis points for each unit of
Duration risk. That is pretty thin.
At long last
When digging, it seems like there is no pony in the company
Bond market. What we found is that investors seem to be
Plowing money into the corporate loan market indiscriminately without giving
thought a lot about the minimal returns and the increased risk. As we described on
On several other occasions, this is another symptom of passive investing
Compare the corporate return per unit of duration metric with the same metric for
We may have found our pony Mortgage-Backed Securities (MBS). The
The following table provides a comparison of the yield per unit of duration ratios from
End of January:
The worst risk-reward categories are in the corporate bond sectors with very low ratios.
As shown, the ratios are currently almost two standard deviations, which are rich in
the average. Conversely, the MBS sector has a rate of 0.863, which is almost the same
three times higher than in the corporate sectors and almost 1.5 standard deviations
about the average for the mortgage sector.
Another connection with the ratio of MBS yield per unit of duration to investment grade rating is shown below
Corporate sector. As shown, MBS are the cheapest compared to MBS
Company since 2015.
Courtesy of Brett Freeze – Global
MBS, such as
those issued by Fannie Mae and Freddie Mac are guaranteed against default
the US government, which means that unlike corporate bonds, the bonds will
always ripe or repaid at face value. They are assessed on the basis of this protection
AAA. MBS also have the added benefit of being well diversified in themselves. The
Interest and capital on a mortgage bond are covered by thousands and even tens
from thousands of different homeowners from many different geographic and socio-economic areas
Locations. Perhaps most importantly, homeowners are desperate to keep them
the roof over your head
A bond issued by IBM is only secured by this one company and its capabilities
service the debt. Regardless of how many homeowners fail, an MBS investor is
guaranteed to receive par or 100 cents on the dollar. IBM or other investors
other corporate bonds, on the other hand, may not be as lucky.
It is important to note that when an investor pays a mortgage premium, you say a
$ 102 price and receives par in return may result in a loss. The
The determining factor is how much cash flow has been received from coupon payments
Time. The same applies to corporate bonds. What differentiates companies
Bonds from MBS mean that the risk of a large loss for MBS is much lower.
Like the diagram
The table above shows that MBS with an AAA rating are currently very cheap
Risk return compared to investment grade corporate bonds at a comparable price
The world is distracted by celebrities who invest in FAANG shares, Tesla and now corporate
We prefer to find high quality investment opportunities that deliver excellent results
risk-adjusted returns, or at least an improvement.
The analysis suggests one of two outcomes for fixed income securities
Markets. If you are looking for fixed-income securities
Credit exposure, they are better served to shift their asset allocation to a
Stronger weighting of MBS compared to investment grade corporate bonds. Secondly,
This suggests that corporate bond exposure will be reduced directly
prudent given their extreme ratings. Although cash or the money markets
don’t offer much yield, they are always powerful in terms of option it
lends itself when the stock and bond markets finally come to their senses
and undo mine.
With so many
Assets with historically expensive valuations, it is a difficult time to be
an optimist. Despite the limited options available, knowing this is encouraging
If there are still a few ponies nearby, you just have to hold your nose and get a little
dirty to find it.
Note: We are not the author of this content. For the Authentic and complete version,
Check its Original Source