This quote was a lead item in Michael Gayed’s Lead-Lag report on July 24th:
The worst of the worst credit tier, CCC-rated and below, has seen its yield spread rise by 116 basis points since its mid-March low. And this rise hasn’t been choppy either. It’s been a slow and steady climb that tends to more often signal a genuine change of sentiment than just a reactive move.
(“This Could Be The Crack In The Dam,” https://leadlagreport.substack.com/p/this-could-be-the-crack-in-the-dam
I believe Michael was correct in calling attention to this early-warning indicator. On July 24th and after all the political turmoil, the CCC option adjusted spread (OAS) to US Treasurys was about 800 basis points and that is higher than at the end of March. Source: Bloomberg.
Consider the difference between the Baa option-adjusted spread (OAS) and the CCC spread that Michael discusses in his Substack post. The Baa OAS on the same date was 111. Thus, the gap between Baa and CCC was nearly 7 full percentage points and widening. Baa is the lowest of the investment grades in corporate debt. CCC is in the deep junk category. Any lower would be in the category of defaulted bonds. So, what we are seeing is a widening in the credit spread of the weakest existing corporate credits. In other words, market agents are changing the price of how they assess the risk of default in this junk bond category. As Michael points out in his post, this appears to be a gradual trend and not just a volatile spike. He notes that this has been underway since March.
Market agents make real-money bets, and that is why I respect market-based prices more than TV punditry. Market agents may not always be right, but they are “putting their money where their mouths” happen to be at that moment.
Who are these junk-bond-rated folks? They are the companies that are the most speculative stocks, or they may be operating at losses, or they may be innovative or research and development enterprises. You rarely find them in the S&P indices, whether the 500 large-cap or 400 mid-cap or 600 small-cap. The reason is that the S&P committee replaces companies that are persistently loss creating with others. S&P wants companies that make profits.
You will however find them in the Russell 3000 Index or the total-market-type broad indices. And that is why those ETFs are reactive to credit spread widening in the lower-credit-quality arena. Anyone wanting details about this and how Cumberland addresses it in equity portfolios can go directly to my colleague Matt McAleer, our President and Director of Equity Strategies. In the fixed-income arena, Cumberland favors the investment-grade bonds and tries to avoid these lower-grade credits. John Mousseau, Ben Pease, and others can discuss credit with you. Email if you want the conversation.
On July 5th, and since March 29th (end of first quarter) the Baa-OAS spread is a few basis points (2 or 3) wider than where it was at the end of the quarter – essentially unchanged. But the CCC-OAS is about 70 basis points wider, and the trend appears to be that more widening is ahead of us.
Is the gradual economic slowing going to accelerate? Is Fed policy becoming too tight? Do the political winds blowing around the world and in the US bode ill for those higher-risk American companies that are in this lower-credit-quality category? There are many questions. Spreads don’t tell you why they are widening. Or narrowing. They just do it, and the rest is left to observers to try to figure out. The real-money bettors have already spoken with their wallets.
Hat tip to Michael Gayed for his observations about CCC credit spreads. I look forward to greeting him and the full group in person at Camp Kotok this August.
Now, let me get a little technical for those readers who wish to spend a few extra minutes.
The way to evaluate the appropriateness of a credit spread is to first observe the enterprise value (EV) for the specific company. For readers who wish to learn more, I recommend some reading about EV and the ways to estimate it. I will skip the tutorial and go right to the issue. One must take the worst-case assumptions for a credit spread analysis. Then estimate when the EV reaches the point at which the company defaults on its debt. Estimate the “burn rate” and you get to an estimate of the date when the default might occur. I say “might” because it also might not. There are lots of reasons it might not, such as the company being a good idea that needs more capital and gets an additional capital investment. Or the company has some value derived from its sunk costs and there is a merger or reorganization transaction. Note that the credit spread may have a premium in it because of the option value of these various outcomes which are better than default. That is why one must try to divide the value into true worst-case EV and then consider the additional value of the company because of these options. For those readers still with me, you must then add riskless interest rate assumptions into this analysis, since the D2D (distance to default) is sensitive to them.
For credit spread analysis, one starts with the worst case. Then compute an estimate of the D2D. A credit rating of CCC is saying that the time left before a default isn’t very long. A Baa credit says the company is likely to continue in business and therefore default risk may exist, but it is small. For the technically curious, George Robertson published an excellent discussion of the issue of EV and D2D and credit ratings. You can read it at his Substack: “Credit – AA, BB and High Yield,” https://themonetaryfrontier.substack.com/p/credit-aa-bb-and-high-yield.
