A strong rebound from the brief selloff that followed the U.K.’s June 23 Brexit vote increased the high-yield market’s already extreme overvaluation.
Between May 31 and June 30, the option-adjusted spread (OAS) on the BAML High Yield Index widened from 597 bps to 621 bps, but over the next two weeks, through July 15, it tightened to 542 bps. That spread-narrowing more than offset the reduction in our Fair Value Model’s indicated spread from 806 bps to 787 bps between May 31 and June 30.
On June 30, the difference between the actual OAS (621 bps) and our fair value estimate (787 bps) was –166 bps (the following chart provides historical perspective). That put the fever line well below the horizontal line that marks –1 standard deviation (–126 bps), by which we define an extreme overvaluation. The July 15 OAS of 542 bps was a still more staggering –245 bps (1.9 standard deviations) from fair value.
By way of background, our basis for determining whether the U.S. high-yield market is fairly valued is the methodology introduced in “Determining fair value for the high-yield market”. (This report is also available at highyieldbond.com.) We are now using an updated analysis to reflect revisions to originally reported economic data, based on a historical observation period of December 1996 to December 2012.
In brief, we find that 81% of the historical variance in the BofA Merrill Lynch US High Yield Index’s OAS is explained by five variables:
- Credit availability, derived from the Federal Reserve’s quarterly survey of senior loan officers
- Capacity utilization
- Industrial production
- Current speculative-grade default rate
- Five-year Treasury yield
Between May and June, capacity utilization increased from 74.9% to 75.4% and industrial production rose from –0.4% to 0.6%. The resulting declines in the fair value spread were partly offset by a drop in the five-year Treasury yield—which is inversely correlated with the spread—from 1.36% to 1.02%. The default rate, a backward-looking indicator with minimal impact on the spread, rose immaterially from 4.1% to 4.3%.
One caveat in the analysis is that the most powerful variable, credit availability, is reported only once a quarter and June was the last month within the reporting period. Very extreme overvaluations in such months sometimes appear overstated in retrospect, as the next quarter’s figure moves sharply in the direction of greater credit availability. (Presumably, the large shift to easier credit in those cases did not occur entirely in the first month of the subsequent reporting period.)
This analysis is part of a weekly research piece on LCD News, authored by high yield expert Martin Fridson. Marty also publishes a monthly analytical piece on LCD News.
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