The media is quick to tout each vagary of the market as the start to the next major sell off. However, not every fluctuation is of equal likelihood to lead to significant spread widening in the overall credit markets. Barring one-off technical events and systematic risk-off periods (e.g., the global financial crisis in 2008), we find that periods of meaningful widening in credit spreads are usually the result of one of two phenomena.
Using the Bloomberg Barclays U.S. High Yield Index (HY) as the subject of our study, we find that historical spread widening is predicated on either:
- One substantially-sized industry weakening significantly (e.g., the commodity crisis of 2014-2015)
- Multiple important industries simultaneously experiencing substantial weakness (e.g., the Telco Crisis / Accounting Fraud period of 2001-2002)
These conclusions are simple and the math behind them is straightforward. In order for the overall index to widen meaningfully, a large industry needs to experience outsized problems or a handful of industries need to collectively weaken. As shown in Figures 1 and 2 below, every major HY market spread widening event since the late 1990s has entailed problems of sufficient size or breadth in index weight and a meaningful magnitude of spread widening within the problem industries.
Identifying a Potential Credit Sell Off: What Should Investors Look For?
For one industry to meaningfully infect the investment grade or high yield credit markets, a feedback loop is needed. Feedback loops can occur through the debt market’s concentrated exposure to a specific industry, a meaningful employment or economic impact from an industry, or weakness in other market industries with high exposure to a specific problematic industry. In each of the examples shown in the figures below where the HY Index widened by more than 150 basis points, a feedback loop expanded the weakness of one industry into the overall HY credit market.
When attempting to identify future credit market sell-offs, it is important to keep these historical characteristics of market sell-offs in mind instead of getting caught up in the concerns that new headlines may promote in response to every adverse market fluctuation. In general, for credit markets to experience significant turmoil, a large industry must undergo major weakness or a number of industries must widen at the same time either due to idiosyncratic or systematic events. In the current environment, many investors have pointed to the retail industry as the next catalyst for broader spread widening. However retail is a very small component of the overall credit market.
As investors, our task is to look for potential catalysts of volatility, both macro or micro, and assess the likelihood of it leading to broader market weakness. The analysis in the charts below provides helpful context for analyzing developments in the current credit market.
Figure 1. Size Matters: Large Industries Have the Potential to Impact the Broader Credit Market
Source: Voya Investment Management, Bloomberg. 1997 - May 31, 2017. Represents spread change for Bloomberg Barclays U.S. High Yield Index (“Index”) versus spread change for the largest industry component of the Index.
Figure 2. Volatility in a Collection of “Problem” Industries Has Also Created Broader Spread Widening
Source: Voya Investment Management, Bloomberg. 1997 - May 31, 2017. Represents spread change for Bloomberg Barclays U.S. High Yield Index (“Index”) versus weight of industries widening by >= 100 bps.
Past performance does not guarantee future results.
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