Wednesday, March 17, 2010

Quality Spread Rotation...

Earlier this week EconomPic took a look at the relative returns of high yield vs. investment grade corporate bonds given the spread between the yield levels of the two. In a nutshell, when spreads between high yield and investment grade are 600+ bps, high yield has significantly outperformed. Otherwise, performance has been mixed (see chart).

Below, equities are thrown into the mix. The chart uses the same x-axis as yesterday's analysis (the spread between high yield and investment grade corporate bonds), while the y-axis shows one year forward excess return of both the S&P 500 (including dividend reinvestment) and high yield.

Unlike the strong correlation between changes in high yield spread and the performance of the S&P 500 that we've seen in the past, the performance of each is very different when spreads are low or when spreads are high*.

Which leads to the next chart detailing returns of investment grade, high yield, and the S&P 500 using the same "spread" metric, but showing the average annual performance of each in absolute terms across three "spread buckets" since 1994.

Now the fun begins.... assigning a 'best performer' to each bucket (S&P 500 when spreads are narrow, investment grade credit when spreads are "mid", and high yield when spreads are wide) and allocating monthly to the 'best performer' based upon the month-end spread differential between high yield and investment grade, we get the 'rotation' returns generated below.

While investment grade, high yield, and equities (i.e. the S&P 500) have all provided remarkably similar returns since 1994 (which is as far back as I was able to pull high yield spread data), the 'rotation' returns have significantly outperformed, up more than 11% per year with a similar level of volatility (compared to 7.3% annualized returns for the S&P 500 with more than 15% volatility).

It will be interesting to re-run the analysis as I dig up high yield data going back further, but in the meantime we need an official name for this type of rotation as "Quality Spread Rotation" isn't cutting it.

Any ideas?

Source: Barclays Capital

* Low:

When spreads between high yield and investment grade are low it likely:

  • Means that more investors are risk seeking on the margin
  • Reflects a decent economic environment
  • Equates to cheap fixed income financing for corporations (low spreads on borrowing costs)
All of which feed into higher earnings (all else equal) and earnings flow through to equity investors. Throw in the potential P/E multiple expansion when spreads are tighter and you get a great environment for equities.


When spreads are high, those higher coupon payments are made to the high yield investor and everything detailed above is reversed. At the same time, high yield investors have a more secure spot in the capital structure than owners of equity, thus first rights to a corporation's assets if there are defaults (i.e. they have recovery value, whereas equity investors do not).


  1. When yields are low, equities thrive because financing costs are low.

    When the defaults come, future equity returns are low, because financing rates rise, killing some and wounding others.

    When yield spreads are very high, future equity returns are high, because returns come as spreads tighten.

    You can see more on pages 14-22 of this presentation that I gave:

  2. thanks david! didn't mention this last time you posted, but really like your work.