Commentary on Political Economy

Thursday, 14 January 2021

 

Bond Market’s Scariest Gauge Is Worse Than Ever

Corporate credit markets are more exposed to duration risk than at any other time in history.

This could be a credit investor.
This could be a credit investor. Photographer: Gabriel Bouys/AFP/Getty Images

Around this time a year ago, I ruffled a few feathers among bond traders with the headline “This Is the Scariest Gauge for the Bond Market.” The upshot was that when looking at the ratio of yields on corporate debt relative to its duration, investors were more susceptible to losses from a move higher in interest rates than at any time in history.

Well, if that gauge was scary in January 2020, it’s downright terrifying now.

The “Sherman Ratio,” named after DoubleLine Capital Deputy Chief Investment Officer Jeffrey Sherman, basically shows the amount of yield investors earn for each unit of duration. It tumbled to as little as 0.1968 on Dec. 31 for the Bloomberg Barclays U.S. Corporate Bond Index, a record low in data going back more than three decades. That compares with the previous low of 0.3467 I flagged in early January 2020. And while that former milestone wasn’t too much lower than previous instances, current investment-grade corporate-bond yields are an outlier in every sense of the word.

No Buffer

It only takes a small move in rates to wipe out high-grade bond returns

Source: Bloomberg Barclays index data

As was the case last time around, this is happening because the numerator (yield) has continued to tumble while the denominator (duration) increases. The average investment-grade corporate bond yield was a record-low 1.74% as of Dec. 31, compared with 2.84% a year earlier, while the modified duration on the index increased to 8.84 years at the end of 2020, just about a record high, from 7.96 years at the start.

The first week of 2021 demonstrated how potentially perilous this dynamic can be for credit investors. Investment-grade corporate bonds suffered their worst loss since August, and second-biggest decline since March, even though spreads narrowed and there’s no sign of broad stress in high-grade markets. Duration, for the unfamiliar, is simply a measure of a bond’s sensitivity to a given move in interest rates. For example, a security with a duration of five years would gain 5% if rates fell 100 basis points or lose 5% if rates rose by 100 basis points.

While one-way moves of that kind of magnitude are rare, benchmark 10-year Treasury yields did increase by 20 basis points in the first five trading days of the new year. So with the duration of the corporate-bond index at almost nine years heading into 2021, it’s basic math (roughly 8.84 times 0.2%, with a slight adjustment for spread tightening) that investment-grade bonds lost 1.52% last week. It really doesn’t take much of a move higher in interest rates to wipe out the income return on the index or a fund tracking it.

Yes, U.S. yields have retreated so far this week, providing a reprieve from the losses. But the Sherman Ratio should serve as a reminder to those investing in corporate bonds that they’re effectively buying U.S. Treasuries with slightly higher yields. To that point, the 120-day correlation between the iShares 20+ Year Treasury Bond exchange-traded fund (ticker: TLT) and the iShares iBoxx $ Investment Grade Corporate Bond ETF (ticker: LQD) reached 0.73 on Wednesday, the highest since March 6. A reading of 1 implies the two funds move in perfect lockstep; a reading of negative 1 signals they move in entirely opposite directions. On a 60-day basis, the correlation is 0.8.  

All About Those Rates

Corporate-bond ETF is trading more in sync with Treasury ETF lately

Source: Bloomberg

It’s certainly reasonable to expect that high-grade corporate bonds will outperform Treasuries as the economy recovers. But it doesn’t seem as if they’ll do all that much better. The average yield spread is just 95 basis points, compared with a post-financial crisis low of 85 basis points set in February 2018 as the Federal Reserve was in the middle of its tightening cycle and benchmark yields were racing higher. And the index has become somewhat riskier since then —  triple-B rated bonds make up more than 50% of its market value, up from 48% in early 2018. All else equal, that makes it tougher for spreads to tighten further.

The Sherman Ratio is meant to “calculate what percentage increase in rates will offset a bond fund’s yield,” according to DoubleLine. For fixed-income investors who think 10-year Treasury yields will continue to move up this year as more Americans receive Covid-19 vaccinations, perhaps reaching JPMorgan Chase & Co.’s recently revised forecast of 1.45%, one of the few choices left that doesn’t lock in losses is junk bonds. The Sherman Ratio on the Bloomberg Barclays U.S. High Yield Index isn’t exactly appealing — it fell to a record low of 1.15 last week —  but the securities are more insulated from interest-rate swings with a duration of just 3.64 years, less than the five- and 10-year average. 

Duration Defense

The Sherman Ratio for junk bonds is historically low, but much higher than it is for investment-grade debt

Source: Bloomberg Barclays index data

As I noted last year, holding investment-grade corporate debt only lost investors money six times since 1981, but those instances are becoming more frequent, including 2013, 2015 and 2018. The nearly four-decade bull market in bonds has erased the income buffer that provided steady gains regardless of short-term volatility in benchmark Treasury yields. We’ve reached a point that even a 20-basis-point move is enough to wipe out a $6.75 trillion index of company debt.

That’s just one more reason to expect the Fed will push back against any swift move higher in U.S. yields. A slow and steady climb like the one in the second half of 2020 is one thing. Even last week’s jump above 1% was tolerable, given the outlook for additional fiscal stimulus now that Democrats will control the Senate in addition to the House and the presidency.

But as I said when 10-year yields crossed 1%, now comes the hard part, both for the Fed and bond traders. At the central bank, officials are already starting to walk back last week’s taper talk. Meanwhile, Treasury yields retreated after strong auctions as yields approached levels that some viewed as attracting demand from overseas investors. HSBC Holdings Plc put out a report that said in no uncertain terms: “Buy U.S. Treasuries after yield spike.” It’s likely to be a grind from here.

That’s great news for corporate-bond buyers who can ill afford a sharp move higher in interest rates. It seems as if no matter how low the Sherman Ratio goes, fixed-income investors always manage to avoid the nightmare scenario.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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