Spreads on both corporate and high yield bonds have increased significantly in recent weeks. Nevertheless, especially the spreads on high yield bonds remain too low. Let’s get under the bonnet to explain why this is the case.
As the chart below indicates, corporate and high yield spreads are highly correlated. However, in recent weeks the spread combinations of both asset classes have been in the orange oval, indicating that high yield bonds are on the low side, compared to what you might expect based on history. The last data point is the pink square.
To find a possible explanation for the divergence in spreads, we need to look under the bonnet of our Global Multi-Asset ETF portfolios. The table below shows the sector distribution of the Lyxor Global High Yield Sustainable Exposure ETF (the sector distribution of other well-known ETF providers looks very similar). The focus here is on the weight of energy (5.65 percent), basic materials (8.46 percent) and financials (15.2 percent).
The following table shows the sector distributions of the Lyxor ESG USD Corporate Bond ETF and the iShares EUR Corporate Bond ESG ETF. Again, focus on the weights of energy, basic materials and financials.
The weight of the first two sectors is significantly greater within the high yield universe than within the corporate bond universe. With commodity prices through the roof, it should come as no surprise that companies in these sectors are performing particularly well. The cash flow generation of these companies is strong, reducing the likelihood of bankruptcy. As a result, bond spreads for companies in the energy and basic materials sectors have widened much less than ‘average’ when the economic outlook worsens.
In addition, we have seen a flattening of the - and in the case of the US even a negative - yield curve in recent months. This is generally less good news for banks etc., which benefit from a large interest rate differential between short and long term lending. Financials have a very large weighting in most corporate bond benchmarks.
Recession opportunities
The sector distribution of corporate and high yield bonds explains at least part of the gap between the spreads on these asset classes. Nevertheless, this does not automatically mean that corporate bonds are attractive in a well-diversified multi-asset portfolio. As a rule, spreads are still low. So low that corporate bonds reflect only a very small probability of a recession. High yield bonds do not even reflect a recession risk at all.
Jeroen Blokland is the founder of True Insights, a platform that offers independent research to construct diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco.