As markets sold off in March, investors were forced to sell what they could. This created dislocations in the market, as large, liquid capital structures underperformed, the synthetic market outperformed bonds and credit curves inverted.
In addition, investment-grade credit underperformed the high-yield market. At some points, the spread ratio of high yield over investment grade traded two standard deviations below its recent historical average (see figure 1).This was driven in part by the growth of the investment-grade market relative to high yield, particularly the BBB-rated segment.
Figure 1. Investment grade moves from cheap to rich
Source: Federated Hermes, ICE Bond Indices, as at July 2020.
As a record amount of fallen angels were downgraded to high-yield status, the Federal Reserve came to the rescue and announced support for this part of the market. At the same time, numerous indicators suggest that the broader market is normalising, while central-bank easing has prompted a convergence between the US and the rest of the world.
Demand for investment-grade credit has recovered and the spread of high yield over investment grade has risen to two standard deviations above its recent historical average, meaning that high yield now looks better value. As investors choose to remain in the senior part of capital structures, high-yield credit should remain in favour – a dynamic that is also supported by central-bank support, the mandatory nature of coupons and fact that the high-yield market has the highest average credit rating on record.