The Big Idea
Spotting value through spread percentile ranks
Dan Bruzzo, CFA | September 15, 2023
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
The investment grade corporate bond index has spent much of 2023 recovering from the March domestic regional banking crisis. But now spreads have reached an inflection point. The option-adjusted spread on the investment grade index is currently trading near the midpoint of its 5-year range, making this a good time to look for ‘tight’ and ‘wide’ relative value opportunities. This note introduces a new approach to finding those opportunities, and the approach points to clear opportunities to rotate within sectors, across sectors and across duration.
The new approach is designed to track where spreads currently stand compared to historical performance across a wide range of markets. This helps identify relative value within the investment grade sector. For each different breakdown of the index—sector, subsector, ratings category, duration and so on—the approach assigns a percentile rank that depicts where current option-adjusted spreads for each sub-index compare over the last five years. Different parts of the market should trade at different nominal levels, reflecting differences in their embedded risks. But when a sector trades wide or tight relative to past levels, it sends a signal. Absent any fundamental changes in underlying risks, a shift in spreads relative to past levels helps identify areas of the market that may be overbought or oversold assuming relationships are more likely to revert to their historical norms. Sometimes all sectors may be overbought or oversold because of general spread tightening or widening. But when percentile rank differs across sectors, there is possible opportunity.
The first pass through the market calculates the 5-year historical OAS percentile rank by individual sectors in the investment grade index (Exhibit 1). The percentile ranks (blue bars) range from 0% to 100% based on where spreads are currently and are arranged from lowest to highest. The nominal OAS levels (orange bars) are also provided to illustrate where average spreads lie for any individual sector. The lower readings for percentile rank on the left side of the graphic identify option-adjusted spreads for each sector that are currently lower than normal, and therefore potentially suggest that the sector is currently trading tight or overbought. Transportation, energy, consumer—both cyclical and non-cyclical—and capital goods are among the lowest percentile ranks in the sector study. Alternatively, brokers/asset managers/exchanges, banking, REITs and utilities make up the bulk of sectors that are currently at spread percentile levels that are north of the investment grade index This is not a surprising group of names given that this year’s most noteworthy credit concerns have been rooted in the banking sector, while REITs have been under increased scrutiny with secular concerns arising for corners of the commercial real estate market amidst higher rate volatility.
Exhibit 1. Investment Grade Sectors – Spread Percentile Rank vs Nominal OAS
A second pass through the market drills a further layer down into the broad industrial sector, in order to give a more detailed account of how OAS are currently being valued at the industry or subsector level compared to their 5-year historical performance (Exhibit 2). The tightest trading subsectors include oil field services, refining, railroads, restaurants and midstream energy according to their current percentile ranks. At the other end of the spectrum are consumer services, which includes concentration in web-heavy names such as EXPE, EBAY and BKNG, home builders, media, cable satellite and gaming. If spread tightening were to resume in the final quarter of the year, those segments appear most poised to outperform the other industries within the broader industrial index.
Exhibit 2. Industrial Subsectors – Spread Percentile Ranks
A third pass similarly drills down into the subsectors within the broad financial sector (Exhibit 3). The only two subsectors falling below the investment grade index in current OAS percentile rank are health and life insurance; other financial is negligible to the rest of the sector. This is likely because these two sub-indices have larger concentrations of high duration securities, given the extraordinary demand (and somewhat limited supply) for longer-dated paper that has been extremely evident in the secondary market over the past several months. Not surprisingly at all, the subsectors at the other end of the spectrum include Office REITs, and both the senior and subordinated banking segments. While spreads in the domestic banking sector have begun to normalize as credit has generically recovered since March, regional bank credit is still trading fairly wide to historic norms, accounting for the significantly high percentile ranks in those areas versus the five-year historical period included in the study. Despite the secular concerns impacting perceptions about the trajectory of Office REITs, we believe underlying credit fundamentals of the investment grade constituents of the segment creates relative value opportunity at current valuations. Likewise, we maintain an ‘undervalued’ opinion on the broad banking sector relative to the rest of the investment grade index.
Exhibit 3. Financial Subsectors – Spread Percentile Ranks
The analysis can zoom back out to the broader sector classifications (industrial, utility, financial) and this time break out the individual rating categories within those segments (Exhibit 4). For the most part, the lower rating categories appear to have more room to tighten relative to their higher rated counterparts. The one exception appears to be ‘Aaa’ rated financials – however, that sub-index does not provide individual constituents and should therefore not be considered statistically relevant to the rest of the study. Not surprisingly, the financial sector’s rating categories have higher 5-year percentile ranks as the highly influential banking sector has lagged the broader recovery in credit.
Exhibit 4. Rating Categories by Broad Sector – Spread Percentile Ranks vs Nominal OAS
The final breakout in this ‘overvalued/undervalued’ study is perhaps the most intuitive relative to the secondary market (Exhibit 5). Again, with rate volatility taking center stage in broader fixed income markets throughout the summer, the demand for longer-dated 20- and 30-year maturities and barbell duration strategies in the investment grade market has been one of the most prominent trading trends year-to-date. This would suggest that many of the better, longer-term relative value opportunities currently lie in the intermediate durations of the broader investment grade market.
Exhibit 5. Index Duration – Spread Percentile Ranks vs Nominal OAS