At the end of October, the Government and the Bank of Japan (BOJ) shocked markets in a collaborated manner. In the morning, the Government Pension Investment Fund (GPIF) announced new asset allocation mix. That announcement had been pretty much expected, but the surprise was the GPIF more than doubled domestic and foreign equity allocations, while cutting domestic bond allocation almost to half. In the afternoon of the same day, BOJ expanded its QQE (Quantitative and Qualitative Monetary Easing) program, deciding to increase their Japanese Government Bond (JGB) holdings at an annual pace of 80 trillion yen (from 50 trillion yen) and to triple the annual purchase of ETF and J-REIT to 3 trillion yen and 90 billion yen, respectively. And another surprise came ten days later, when various media reported that Prime Minister Abe is planning to postpone the next consumption tax hike taking effect in Oct 2015 and to have a snap general election this coming December.
What were these actions all about? It’s clear that while Abenomics had been losing confidence under much weaker than expected GDP growth and falling inflation rate in recent months, the Gov’t and BOJ urgently needed ways for revitalizing Abenomics by again showing their stance that they do everything in order to achieve 2 pct inflation target and to raise potential growth rate of the Japanese economy. The GPIF and BOJ effectively engineered a way that PM Abe could buy a fairly long period of time, establishing a scheme that through making domestic bond investment totally unattractive, not only the GPIF and other public pension funds but also private sector investors would advance into a large scale portfolio rebalancing, purchasing risk assets both in domestic and overseas markets in a foreseeable future.
On political front, PM Abe decided to call the lower house election in the next month. It can be seen as odd, given that right now the Liberal Democratic Party (LDP) commands a substantial majority in both the lower and upper houses of the Diet (Japan’s bicameral legislature) but seemingly he judged that he needs to take a risk now and have another strong win in the election for remaining in office beyond the next year. Indeed a strong victory will strengthen his standing in the Diet/LDP and make easier for pushing through legislation.
These policy initiatives by the Gov’t and BOJ have been succeeding to inflating risk assets and weakening JPY so far, while JGB yields losing grounds gradually. Since the GPIF/BOJ policy changes last month, Nikkei225 has already rose by 11 pct; JPY has depreciated against US$ by almost 8 pct; 30Y JGB yield has declined by 25bp. And given the scale of this time Abenomics revitalization scheme, this market trend could be sustained for at least another few months.
Having said that, however, it does not mean that PM Abe can achieve his ultimate objectives: lifting growth and inflationary expectations. Despite a sharp equity market rise and JPY weakness over the past 18 months, BOJ’s QE in the past has clearly failed to prop up real economic activities so far. If a traditional monetarist approach can not be effective for Japanese economy any longer, a larger scale QE will not have any meaning.
The high yield bond market has posted a return of + 4.78% year-to-date (as of 10/31/14, as measured by the BAML US High Yield Master II Constrained Index). However, the continued uncertainty around the strength of global growth, coupled with evolving global central bank policies, has lead to an increase in market volatility. Left in the path of these recent episodes of volatility is a trail of dispersion of returns within the high yield bond market.
Ratings Return Dispersion
At the end of June year-to-date returns by rating buckets were relatively tightly packed. Double-B’s had returned +5.64%, single-B’s had returned +4.97% and CCC’s +5.73%. During the months of July through October market volatility increased and the dispersion of returns by rating categories increased dramatically. At the end of October double-B’s had returned +6.64%, single-B’s had returned +3.97%, and CCC’s only +1.46% (Chart 1)! We have not witnessed such dramatic underperformance by CCC’s relative to BB’s since 2011. 2011 included episodes of volatility and associated risk off trades largely due to the euro-zone sovereign debt crisis and the downgrade of U.S. treasury debt.
High Yield – Dispersion by Ratings: Returns by Ratings Buckets
Since the end of June, CCC’s have widened approximately +150 bps versus double-B’s and now stand at + 511 bps. The current spread relationship is relatively tight versus historical averages, but consistent with other periods of low defaults, 1994-1999 and 2003-2007 (Chart 2).
BB versus CCC spread
Sector Return Dispersion
Diving further, dispersion of returns has also been evident at the sector level. Once again sector returns were similar at the end of June. However, by the end of October dispersion of returns by sector had expanded significantly and the more cyclical, less defensive sectors had performed the worst. During the months of July thru October the worst performing sectors were energy -4.04%, basics -2.43%, and consumer cyclical -1.72%. Ouch! What performed well? Utilities returned +0.81% and consumer non-cyclical returned +0.45%. (Chart 3).
High Yield -Dispersion by Sector: Returns by Sector
Dispersion = Opportunity
Broadly speaking high yield fundamentals are solid. Corporate balance sheets remain healthy and supportive of the high yield bond market. Defaults are expected to remain well below long term averages. However, behind the ratings and sector return dispersion are dramatic individual issuer return dispersion. The market is far less tolerant of credits that disappoint on fundamentals. Complacency has been replaced with scrutiny…that’s good. Episodes of volatility will continue as global central bank policies evolve and drive the inevitable debate around implications for global growth.
Dispersion among many things sows the seeds of opportunity. Fundamentals really matter again. A strong, fundamental, bottom–up security selection investment process paired with disciplined portfolio construction, can uncover and capitalize on opportunities within the high yield bond market.