Fridson: Which high-yield industries are faring best amid rate hikes?

This commentary is written by Martin Fridson, a high-yield market veteran who is chief investment officer of Lehmann Livian Fridson Advisors LLC as well as a contributing analyst to Leveraged Commentary & Data.

The ICE BofA US High Yield Index’s option-adjusted spread, or OAS - roughly defined as the difference between a speculative grade bond’s yield and the yield of a U.S. Treasury bond of similar maturity - reached its monthly low on Sept. 12, at +450 bps. From that date through Sept. 23, the spread swelled to +512 bps, its high for the month up to then. 

Key to that step-up in the speculative-grade risk premium was a growing realization that Jerome Powell and his fellow Federal Open Market Committee members really meant it when they said they were going to stick to their guns in bringing inflation down. The change in market tone culminated in a 0.75-percentage-point hike in the target Fed funds rate on Sept. 21, accompanied by indications from Powell that the rate would rise and the economy would likely slow more than previously expected.

Some high-yield boosters tried to make the case that their asset class was now more attractive than equities or high-grade bonds. They cited long-run breakeven rates involving the spread-versus-Treasuries and expected default losses, which of course have little or nothing to do with near-term returns. In any case, asset allocation is the province of the institutional client or mutual fund shareholder. Managers of dedicated high-yield funds are primarily concerned with generating the highest (or least negative) returns possible within their assigned asset class.

Industry allocation is one potential path to achieving superior relative performance. For portfolio managers who expect returns to remain under pressure from a combination of rising interest rates and weakening economic activity, a breakdown of the most recent selloff can shed light on where the most pain will be felt. The table below provides such a breakdown.

This analysis is not limited to the 20 largest high-yield industries by face amount outstanding that we cover in our monthly updates of returns and industry relative value. Instead, it covers all 37 discrete ICE BofA US High Yield industry subindexes. (The table displays returns for the Gaming index and the Hotels index, for example, but not the combined Hotel & Gaming index.)

Bear in mind that one reason we usually focus on the 20 largest industries is that the smallest industries may be subject to high levels of statistical noise. In an extreme example, the once significant Railroad index has dwindled to a single issue, rated Caa1/B- (see note 1). With that caveat, some useful themes emerge from the ranking by recent returns.

The table divides the 37 industries into three groups. The Pack includes the 29 industries with returns in the range of plus/minus one standard deviation of the mean of -4.17%. They represent 78% of the industries, somewhat more than the 68% that would be in that defined middle range if the returns were normally distributed. Still, the actual distribution displays a degree of symmetry, with four industries each in the range above and below one standard deviation.

Interpretation
At the low-return extreme are three industries from the infamous TMT (Technology/Media/Telecom) bloc that went through a spectacular boom-and-bust cycle in the late 1990s and early 2000s. Cable & Satellite TV, Entertainment & Film, and Telecommunications took a heavy hit in the Sept. 12-23 period. They were joined at the bottom end by Super Retail (department stores, discounters, and specialty retailers). On the whole, this collection of industries suggests that the market expects weakness in consumer spending.

None of the four best-performing industries are among high-yield’s 20 largest, making them susceptible to the abovementioned problem of statistical noise. They are Banking & Thrifts, Environmental, Railroad, and Transportation Excluding Air and Rail (that leaves shipping). The largest among them, Banking & Thrifts, with a somewhat respectable 20 issues, is noteworthy for its strong connection to interest rates. Banks are widely regarded as beneficiaries of rising interest rates, provided consumers do not get squeezed by inflation to the point where they begin defaulting on loans in large numbers.

Falling just short of one standard deviation better than average, but in the top quartile, is high-yield’s largest industry, Energy. There is no likelihood of statistical aberration in the finding that this commodity-price-sensitive industry was among the recent selloff’s strongest performers. By contrast, the other most prominent commodity-price-sensitive industry, Metals & Mining, showed middling performance at #15 out of 37.

Energy has a unique story, with the Russia-Ukraine war bolstering oil and gas prices in the face of a weakening global economy. Apparently the market expects that situation to persist for some time. By contrast, basic industries that are closely tied to the business cycle produced moderately below-average returns, namely Capital Goods, Chemicals, and Steel.

Research assistance by Zhuojun Lyu and Yinuo Lai. 

ICE BofA Index System data is used by permission. Copyright © 2022 ICE Data Services. The use of the above in no way implies that ICE Data Services or any of its affiliates endorses the views or interpretation or the use of such information or acts as any endorsement of Lehmann Livian Fridson Advisors LLC's use of such information. The information is provided "as is" and none of ICE Data Services or any of its affiliates warrants the accuracy or completeness of the information.

Notes

1. As an indication of the locomotive industry’s one-time prominence in the speculative-grade market, at the dawn of the high-yield modern era in the late 1970s, the husband of one of my colleagues made a good living exclusively by buying and selling bonds of bankrupt railroad companies. This comparison is not apples to apples because defaulted bonds are not included in the ICE BofA US High Yield Index. As recently as 2009, however, the Railroad index contained nine issues that in aggregate represented 0.28% of the ICE BofA US High Yield Index’s market value, versus one issue and 0.05% currently. In a similar vein, the ICE BofA US High Yield Textile & Apparel Index is now defunct, but back in the 1990s it warranted the allocation of at least half of a senior analyst’s time.

This article originally appeared on PitchBook News