Eric Lim, CFA
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As the number of new coronavirus cases outside of China continues to rise and the oil price war between Saudi Arabia and Russia ensues, spreads of credit default swaps have widened hand-in-hand with the spreads of high yield bonds. Our chart this week will examine what this means for investors.
A credit default swap (CDS) is a derivative security that insures against default on a bond. In other words, the price of a CDS shows the market’s projection of the issuer’s likelihood of defaulting. Referred to as a spread, the price of a CDS is tracked in basis points, similar to the spread of a bond. Currently, the broad high yield CDS index, called the high yield CDX,¹ has a spread of 551bp as shown in the gray line. This means that a CDX investor must pay $5.51 per year to insure $100 worth of the high yield bond index from default. This is a near-term high, as the CDX’s spread was as low as 275bp in early January when it cost only $2.75 per year to insure $100 worth of the high yield bond index from default. But it is not as high as the point it reached in mid-February 2016, the peak of the U.S. shale crisis when it cost $5.89 per year to insure $100 worth of the high yield bond index from default.
A high spread for the CDX index means that the market is assigning a higher average likelihood of default to high yield bonds today as a result of the forward economic fallout from lower expected corporate earnings due to the coronavirus as well as the difficulties energy companies will have to endure due to the low price of oil. However, this high CDX spread also suggests attractive prices of the underlying bonds. Shown in the blue line, option-adjusted spreads for high yield bonds have widened to well above long term averages, signifying a compelling opportunity. With the U.S. consumer still on strong footing, high yield issuer fundamentals remaining moderate, and China in recovery mode as their coronavirus cases are declining and capacity utilization is rising, we would encourage investors to consider adding to their high yield allocations through dollar-cost averaging over the next few quarters, in accordance with the adage “buy fear, sell greed.”
¹Inception of the high yield CDX was in 2012, while inception of the high yield bond index was in 1994
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