In the latest Macro Credit note from Goldman Sachs’ Credit Strategy Research group, Lofti Karoui admits that the Fed’s shift coupled with thin spread valuations most likely puts the trough in USD spreads behind us, as risk premia continue to adjust to the prospects of slower growth and a gradual tightening of policy.
In fact, they admit, there has been an almost record erosion of the excess premium in the low end of the USD bond market’s rating spectrum, now trading at their richest since right before completely collapsing in 2008…
But, rather than cash-in your chips and wait for better opportunities (because how is a lowly i-bank gonna earn the spread and the commish if you don’t trade), Karoui and his credit group suggest you ‘rotate’ from simple (extremely rich) credit exposure to more complex (and slightly less expensive) credit assets.
The exact wording could not be more ‘doublespeak’ as the bank says they:
“also shifted to a more defensive posture, preferring the “complexity premia” offered in structured products such as CLOs and consumer ABS.”
So buy BB CLOs and sell your HY bonds because… elevated valuations coupled with the Fed’s shift leave little room for further compression in risk premia…
Historical percentile ranks for various bond index spreads. We use OAS for the HY, IG, agency MBS, and credit card ABS indices, discount margin for CLO tranches, and Z-spread for non-agency RMBS.
And we can only guess how much wider the bid-ask spread is on those ‘complex’ assets (ker-ching).
Buried deeper in the report, Goldman does admit there are ‘some risks’ to this decision at such extremely elevated spread valuations…
…risks naturally skew to the downside, especially over longer horizons. Coupled with the ultra-level of implied volatility, both on an absolute basis and relative to the equity market, we think this provides a good entry point to add hedges. In the near to medium term, and aside from the spread of new and more vaccine-resistant virus variants, we see three key risks to risk sentiment.
The first is a large inflation shock. So far, credit investors have treated the recent spike in inflation as a transitory shock (rightly so, in our view). But the risk of more persistent upward pressure on prices cannot be ruled out.
Given still negative average real yields in the IG market, investors’ protection against any repricing of inflation risk is non-existent.
The second risk is a premature return of shareholder-friendliness that would weaken liquidity positions and offset the tailwind from strong growth to credit quality. So far, the funding structures of the ongoing M&A wave have remained neutral to bondholders. But low funding costs, record-levels of balance sheet liquidity and elevated valuations in the equity market could gradually turn managements less conservative, from a credit perspective.
The third risk is a change in tax policy beyond what is currently priced in. In recent research, we showed that investors already demanded an extra premium against the risk of a higher statutory tax rate, following President Biden’s election. Should the rollback of the TCJA fuel a larger shock to free cash-flows than what is currently priced in, we think performance could be challenged, particularly among lower rated and over-leveraged issuers.