New NYFed Corporate Bond Distressed Index provides context for spread increases

 

The NYFed has developed a new corporate bond distressed index and it provides some useful information on the tumult in credit markets. More corporate bond stress should lead to higher bond spreads. The index provides some context for spread increases.

Surprisingly, the index states that the investment grade market is going through more stress than the high yield market. This is interesting because high yield corporate bond spreads are showing greater increases than investment grade spreads as measured by the ICE BofA OAS spreads for CCC and BBB bonds. 

The distress index for investment grade is at the highest level since 2016. It is notable that periods of stress post GFC are associate with transitions in monetary policy.

"The CMDI incorporates a wide range of indicators to understand what is driving bond market functioning. Seven underlying sub-indices contribute to changes in the index: secondary market volume, secondary market liquidity, secondary market duration-matched spreads, secondary market default-adjusted spreads, primary market issuance, the spread between quoted and traded prices, and the spread between primary and secondary market pricing."

The Fed is watching this index and it is good to have as macro indicator, but does it tell us something about what the Fed will do? 

Limited diversification across sectors and country indices

 

There was no place to hide with the repricing of equity risk around the globe. The exception was China which was coming out of its spring lockdown. Whether DM or EM markets, the unified move by many central banks to raise rates in the face of global inflation dropped the valuation of equities. The switch in central policies was not coordinated but higher global inflation requires a collective response. 

Major US equity sectors showed declines with energy generating a large reversal based the slowing of oil price momentum. Staples, healthcare, and utilities all provided some protection from the bear market, but that is not the same as generating portfolio gains.

Major repricing of equity and bond markets during June

There was no place to hide as assets repriced given the combination of higher inflation and threats of recession. Growth stocks did better than value, but small cap stocks underperformed large cap names. 

The real downturn for both stocks and bonds occurred with the FOMC move to increase rates on Jun 14th by 75 bps. The market reacted earlier given the telegraphing of the larger move earlier in the week. The big difference between stock and bond performance is that bonds clawed back loses from the Fed shock under the view that a recession is more likely given the Fed's hawkish tone.

The Fed is not the only central bank pushing rates higher. The exception is the BOJ which is continuing its YCC policy. Bank of China is currently neutral. Consequently, the decline in equities is a global shock. The correlated effect of central banks makes equity repricing a common factor.

The fixed income credit markets continued to fall as expected if equities have a large decline. Treasuries and short duration indices showed modest declines; nevertheless, the fixed income asset class year-to-date returns on a risk adjusted basis are the worst in decades. This may not be easily reversed even if there is a global slowdown. 

 

Case-Shiller city price tiers - Low-end (cheaper) homes are riskier than high-end homes

In an earlier post we presented housing price betas for 20 large US cities using the Case-Shiller home price index. (See Case-Shiller housing price index and city price betas - Each city has a different risk profile.) Home price betas will differ markedly by city. 

Case-Shiller also provides city home price data based by pricing level or tiers. Each city has three pricing tiers, low, medium, and high. This allows us to look at the appreciation in the low-end of the market as well as the high-end. One may assume that high-end homes would be subject to more risk and show greater housing betas. You would be wrong. 

Using the same methodology concerning for forming home price beta, we find that the low-end markets are often more volatile and have higher home betas.  City housing price appreciation will be correlated around tiers, but there is still significant variation.

It is noticeable that the losers from the breaking of one housing bubble may be different than the next one. Homeowners who are the most levered may be at the most risk.

Buying a low-end home is riskier than buying a high-end home. The dollars at risk may be greater for the high-end, but the return changes and drawdowns are greater for cheaper low-tier homes. The low-end buyers will be at more risk than high-end buyers if the housing market slumps from a Fed interest rate increase.