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Research

Volatility in rates little seen in HY so far

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Volatility in interest rates year-to-date has unevenly impacted credit markets. Investment grade credit (IG) weakened in sympathy with sovereign yields, especially in high quality and long duration paper. IG bonds were down -3.6% in the U.S. year-to-date, and -0.5% in Europe where rates volatility was lower, with backing from ECB’s purchases. In contrast, HY has been resilient, still up +1.6% in the U.S and +2.5% in Europe, supported by about 60 bps of spread tightening, especially in riskiest HY tranches, as well as in energy in the U.S. and in material in Europe. We review how L/S HY managers on both sides of the Atlantic manage rate volatility and where they concentrate their fire power.

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Volatility in rates little seen in HY so far
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Rate volatility is closely monitored by managers, who hedge the bulk of their interest rate exposures. They tend to use futures or shorts on long-term duration corporate bonds within the higher quality segment (they may short perpetual bond for instance). For now, their hedges have negatively contributed since volatility in HY has not materially soared.

The search for carry, the recovery in oil prices and prospects of economic reopening have further compressed spreads and supported flows. There have been few credit events year-to-date while HY markets remained isolated from the trading anomalies that temporarily unsettled stocks (including short-squeezes led by retail investors or the unwinding of Archegos positions). The asset class has also been less sensitive to the multiple sector and factor rotations that have rocked equities.

Yet, with spreads hovering nearby their 10-year lows, managers see limited tightening potential. Those that outperformed had moved to lower quality tranches. With less than 3% of carry left in HY, they expect investors will favor equities. Overall, they keep a long exposure but less than last year. On the short side, they favor expensive IG bonds while being cautious on fundamental shorts. Indeed, they do not see corporate leverage as a top preoccupation at this stage, considering the mild default wave, the positive economic and profit outlooks, and stimulus support. 

On the long side, they focus on the recovery, especially on cyclical issuers that are likely to rebound the fastest. They are adding some fallen-angels that could return in IG (Carnival Corp. for example) and are starting to increase allocation to UK issuers, to leverage on the fast vaccination roll-out (including bars, supermarket, fitness). In financials, they focus on issuers that still trade in wider spreads (DB and more recently CS for example). They also allocate to legacy tier-one bonds, which will lose their eligibility in banks’ tier-one capital assets (they are less liquid than Cocos but trade at premium). They still allocate to EU periphery issuers, expecting further convergence and more M&A. Finally, they do not see yet an overdose of HY issuance, while they lock in discounts in primary market. 

The low correlation across managers returns emphasizes a differentiated set of themes. The strategy might offer increasingly needed diversification and hedging.

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