Description

Please offer your perspectives/insights in the comments, particularly if they are contrary to my views expressed below.

Investment grade (IG) credit offers one of the best risk-adjusted-return profiles of any asset class, in the current environment.  Spreads, currently above 200bps, remain wide of the Feb 2016 peak and in the vicinity of late 2011 wides, when risk premia on all asset classes were much wider than today.  Much attention has been given to the Fed’s willingness to buy junk (HY) bonds, but their primary focus is on the IG market.  I believe that while a backstop does not yet exist for the HY space, the Fed is committed to maintaining stability in IG.  They have taken the downgrade tail risk off the table for IG, and I believe defaults are likely to remain very low in IG, given the “rolling stone gathers no moss” dynamic at play (i.e., IG market is wide open for new/refi issuance).

I believe the best way to express this trade, in a way that is accessible for non-QIB accounts, is as follows:  

Long: VCIT and VCSH in a $ ratio of 66 to 34

Short: IEF and SHY in a $ ratio of 55 to 45

VCIT and VCSH offer lower duration and a lower expense ratio versus the more widely traded LQD.  IEF and SHY are used to hedge interest rate risk, and this ratio keeps the trade duration ~neutral versus the long VCIT/VCSH.  If you don’t mind the interest rate exposure, you can just go long VCIT/VCSH and forget the IEF/SHY short.  The hedged position carries positively at ~2% and has total return potential into the HSD/LDD% range.

Cash yields zero, equities are fundamentally expensive, and high yield is fraught with default/covenant risk that is arguably not well compensated at current levels.  From a process-of-elimination perspective, IG’s risk-adjusted-return is the best of any major asset class right now.   

Much attention has been paid (by Gundlach, the press, fintwit) to the recovery of LQD to near all-time-highs.  This ignores the fact that the US 10yr has collapsed from 1.6% in mid-February to 0.6% currently.  IG spreads remain quite wide.  It also fails to fully acknowledge the unprecedented and game-changing development of the Fed buying and backstopping IG.  A tightening of spreads to the more historically “normal” 100-125 range would result in +10% upside to VCIT, including the divi.  

Furthermore, there is a rational argument that a yield-starved world with cash rates at <=0% will ultimately result in IG yields also converging on zero.  This would result in upside well into the mid-teens% for this trade.  There is a mountain of cash sitting in money-market funds and the Fed is printing more every day.  This cash is earning zero yield and will be desperately searching for alternatives.  Some high-yield savings accounts still offer yield to depositors, but those rates are falling rapidly.  With its new Fed backstop, IG offers the safest source of yield out there.  Given a persistent lack of low-risk alternatives, I expect retail flows to continue (and perhaps accelerate) into IG.

Getting back to the trade (long VCIT/VCSH and short IEF/SHY), here is how it backtests historically.  First, expressed as a ratio:

 Here it is, expressed as total return over time:

Here it is, in terms of the positive carry:

Below is a breakout of issuer, sector, and ratings exposures for VCIT and VCSH.  Note the relatively high exposure to banks and financials.  This is one of the reasons that IG spreads were hit so hard in the GFC.  Obviously the banks are in a much better place this time, and the Fed (having learned from the GFC) will never let the financial sector’s IG credit be called into question.

DISCLAIMER:  DO NOT RELY ON THE INFORMATION SET FORTH IN THIS WRITE-UP AS THE BASIS UPON WHICH YOU MAKE AN INVESTMENT DECISION - PLEASE DO YOUR OWN WORK.  THE AUTHOR AND HIS FAMILY, FRIENDS, EMPLOYER, AND/OR FUNDS IN WHICH HE IS INVESTED MAY HOLD POSITIONS IN AND/OR TRADE, FROM TIME TO TIME, ANY OF THE SECURITIES MENTIONED IN THIS WRITE-UP.  THIS WRITE-UP DOES NOT PURPORT TO BE COMPLETE ON THE TOPICS ADDRESSED, AND THE AUTHOR TAKES NO RESPONSIBILITY TO UPDATE THIS WRITE-UP IN THE FUTURE.   

Catalyst

Desparate hunt for yield
Fed buying