Two Data items today:
#1: What history says about choosing between investment grade (IG) and high yield (HY) corporate bonds at this point in an investment/economic cycle. Since the start of Q3, IG has outperformed HY on a price basis (LQD ETF +0.6 pct, HYG ETF -0.9 pct) and the relative yield differential over that period (27 bp) is not enough to cover the gap.
This chart shows the difference between HY and IG spreads back to 1997, and that small increase you can just make out on the extreme right-hand side explains part of what’s happened in Q3. HY spreads have widened more than IG spreads, 39 basis points vs. 9 bp (a 10 pct increase vs. 13 pct). As a result, HY bonds have underperformed. The same relationship holds true across this time series, as annotated in the red text. The other reason for the relative IG outperformance is duration (IG at 10 years, HY at 4 years) in what has been a declining long-rate environment since the start of Q3.
As far as what this history says about how to position between IG and HY corporates now, 3 points:
- First, the current difference between HY and IG spreads (250 basis points) is already at levels consistent with high levels of market/economic cycle confidence. The only times it has been the same or lower were in 1997 – 1998, 2005 – 2007, and 2017 – 2018.
- Second, the ratio of IG/HY spreads can remain stable at these levels for a year or longer if (but only if) investors remain confident in future US economic growth.
- Lastly, timing a switch out of HY and into IG is tricky. Since 2006 (last 15 years), IG has only outperformed HY on 6 occasions: 2007 and 2008 (of course …), 2011, 2014 – 2015 (due to lower oil prices since Energy is a large HY issuer), and 2018 (where IG was flat and every other major asset class lost money). (See return history data in link at the end of this section.)
Takeaway: while there will be periods where high yield corporates will lag investment grade (such as the last 7 weeks), we still prefer HY over IG as a yield generating asset class. Yes, we’re at comparable spread levels only seen in stable, robust economies. And, yes, the recent drop in crude prices has not helped HY. But … the long run history shows that HY corporates should continue to be the better way to pick up coupon income than IG bonds on a total return basis.
#2: The latest US state-level unemployment data is out, so we can drill down on how different regions’ joblessness compares to the national 5.4 percent rate in July 2021.
- The median US unemployment rate is lower than the national rate: 4.9 percent (both in Maine and Massachusetts).
- More than half (31) of US states have unemployment levels below the national level.
- The high-population problem areas for US unemployment continue to be California (7.6 pct), the NY tristate area (NY: 7.6 pct, NJ: 7.3 pct, CT: 7.3 pct), and Illinois (7.1 pct).
That last item points to an ongoing problem with US urban unemployment, and the limited city-level July data we have certainly supports that idea:
- New York City unemployment: 10.2 percent in July, up from 10.1 pct in June and 9.9 pct in May.
- Los Angeles unemployment: 10.2 percent in July versus 10.3 pct in June and 10.2 pct in May.
- Chicago unemployment: 8.0 percent in July, better than June’s 9.2 pct but not May’s 7.9 pct.
Takeaway: the US is still seeing a 2-stage labor force recovery, with areas that rely on urban centers to employ large numbers of people distinctly lagging those where populations are less concentrated. The Federal Reserve wants to see more Jobs reports like July’s (943,000 positions added) to justify tapering bond purchases. Equity markets want the same sorts of prints to support stock valuations. We may indeed get another strong report for August at the end of next week, but we remain cautious about US job growth past that. Urban unemployment remains a real problem – NY, LA and Chicago have 1.2 million unemployed people, 14 percent of all Americans looking for work. Until pandemic fears recede further, we don’t see how these levels come down very much.
Asset class returns since 2006: https://novelinvestor.com/asset-class-returns/
State level unemployment: https://www.bls.gov/web/laus/laumstrk.htm