Interest Rates & HY Returns - JPM Study

When Rates are RisingCan Credit Markets Perform When Rates are Rising?

Stephen DulakeJ.P. Morgan Securities Ltd.

103

Can Credit Markets Perform WhenRates are Rising?

When Rates are Rising

Stephen Dulake

European Credit Strategy

7-8 October 2004

Stephen is responsible for European Credit Strategy at JPMorgan, havingjoined in October 2003. Prior to that, he spent nine years at Morgan Stanleyand was a member of the credit strategy team. Stephen has been voted #1 inHigh Grade Strategy by Institutional Investor magazine in 2002, 2003 and2004. He has a degree in Economics from University College, London and amaster’s degree in Economics and Econometrics from the University ofSouthampton.

Stephen Dulake

[email protected]



104

Source: JPMorgan.

A stylistic representation of the year-to-date volatility distribution by risk asset class

Credit(‘Hybrid’)

Govt. Bonds(‘Risk Free’)

Equity(‘Risky’)

‘Volatility’

Perception and the volatility ‘skateboard ramp’

“Loadsa rate volatility, loadsa equity volatility, but not a lot to shout about when it comes to credit”.That’s the current consensus in investors’ minds with regard to 2004, at least based on our own investordialogue. It should be noted, however, that investors are typically thinking along very differentdimensions or axes when it comes to volatility in each asset class; yields in the case of governmentbonds, prices and not options-implied volatility when it comes to stocks, and spreads in the case ofcredit. We will focus on the left-hand side of the volatility ‘skateboard ramp’ and the question is: is thecurrent degree of spread inertia that we see given rate volatility the exception or the rule? And, inparticular, what happens when rates are rising?



105

US investment grade and high yield bonds’ annual returns during interest rate changes

Source: JPMorgan, Ibbotson Associates. For further detail see 2003 High Yield Annual Review, Peter Acciavatti et al, January 2004.

Have we seen this interest rate indifferencehistorically?

Investment grade High yield Intermediate Change incorporate bonds bonds Treasury yield Treasury

1980 0.5% 4.3% 12.5% 152bp1981 2.3% 10.4% 14.0% 122bp1982 35.5% 36.3% 9.9% -407bp1983 9.3% 20.3% 11.4% 84bp1984 16.2% 9.4% 11.0% -33bp1985 25.4% 28.7% 8.6% -225bp1986 16.3% 15.6% 6.9% -185bp1987 1.8% 6.5% 8.3% 147bp1988 9.8% 11.4% 9.2% 135bp1989 14.1% 0.4% 7.9% -102bp1990 7.4% -6.4% 7.7% -72bp1991 18.2% 43.8% 6.0% -175bp1992 9.1% 16.7% 6.1% -72bp1993 12.4% 18.9% 5.2% -66bp1994 -3.3% -1.6% 7.8% 265bp1995 21.2% 19.6% 5.4% -216bp1996 3.7% 13.0% 6.2% 87bp1997 10.4% 12.5% 5.7% -55bp1998 8.7% 1.0% 4.7% -77bp1999 -1.9% 3.1% 6.5% 179bp2000 9.1% -5.9% 5.1% -167bp2001 10.7% 5.5% 4.4% -57bp2002 10.2% 2.2% 2.6% -197bp2003 6.9% 24.4% 3.2% 56bp

In nine of the past 24 years, intermediate Treasury bond yields have risen. Of those nine years,investment grade corporate bond returns have only been negative twice, and high yield bond returnsjust once. The basic point is that even when we attempt to isolate periods when rates are rising, albeitmarket rates, we continue to observe the sort of indifference that we have seen year-to-date.Interestingly also is the outperformance of high yield versus high grade in each of these years. We takethis issue up a little later, and debate whether this really says something about the two asset classes orabout ‘credit’ per se.



106

Fifteen years ending 2003Fifteen years ending 2003

Source: JPMorgan, Ibbotson Associates. For further detail see 2003 High Yield Annual Review, Peter Acciavatti et al,January 2004.1. EAFE = Europe, Africa and Far East

Return correlation across the asset classes

US US US JPMorgan30-day Inter. Long-Term LB Agg. ML Corp. Global HY S&P Wilshire Russell T-Bill Tsy Tsy Bond Master Index 500 5000 2000

US Intermediate Tsy 0.13

US Long-Term Tsy 0.09 0.90

LB Aggregate Bond 0.16 0.94 0.94

ML Corp. Master 0.10 0.87 0.91 0.96

JPMorgan Global HY Index -0.11 0.04 0.13 0.21 0.36

S&P 500 0.08 0.04 0.09 0.17 0.26 0.48

Wilshire 5000 0.05 0.01 0.06 0.15 0.24 0.52 0.98

Russell 2000 -0.05 -0.11 -0.03 0.03 0.14 0.58 0.73 0.84

MSCI EAFE1 -0.05 0.02 0.00 0.07 0.12 0.36 0.63 0.63 0.53

When we look more explicitly at the correlation of returns across the interest rate, high grade and highyield markets, we see, in fact, that interest rate and investment grade corporate bond returns are highlycorrelated, while this appears much less true of interest rates and high yield returns and, indeed, highgrade and high yield returns. Interest rates would seem to us to be important, at least in the investmentgrade market and, relating this to the market environment today, we believe this perception wouldcertainly explain the increased level of participation in the high yield market this year on the part oftraditional high grade credit portfolio managers.



107

330bp 311bp

10bp9bp

27bp

227bp

Investment GradeBond Yield

High YieldBond Yield

’Risk Free’

Swap Spread

Credit

Source: JPMorgan, based on MAGGIE investment grade credit and high yield bond indices.

Disaggregating high grade and high yield bond yields

Total returns and credit returns are two differentthings

� Corporate bond yields may bedisaggregated into three (or more)constituent parts:

– a ‘risk free’ component;– a swap spread component; and– a credit component, which

might be further disaggregatedby sector, rating etc., etc.

� The total return on corporate istherefore a function of these three(or more) components

The total return correlation between interest rate, high grade and high yield markets is, in our view,entirely a function of the relative size of the ‘risk free’ and credit components that make up the all-inyield. In the case of high grade bonds, the ‘risk free’ component dwarfs the credit component and weconsequently observe high correlation between returns on these two asset classes. Interestingly, if wewere to repeat this analysis, but this time calculate the correlation between interest rate returns andexcess high grade corporate bond returns, the relationship all but disappears. This is the argument thatwe made to investors back in November 2003 when we suggested that the Fed represented a ‘redherring’ risk for creditors in 2004, at least from a spread perspective (see The Bermuda Triangle,European Credit Outlook & Strategy 2004, Dulake et al, November 2003). Our inference, when all issaid and done, is that credit and rates do not appear related, at least in a very obvious fashion. Wherewe do think policy and market rates are important for creditors is in shaping the business cycle, no moreso than when we look at the valuation structure in credit markets today.



108

Credit spreads, speculative grade default rates and the downgrade rate

Spec. Default Rate [%] � Industrials Asset Swap Spread [bp]

0

2

4

6

8

10

12

14

16

18

20

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

0

20

40

60

80

100

120

140

Spec. Default Rate

Downgrade Rate

Ave. Downgrade Rate

Ave. Default RateSpec. Grade

Rolling Ave. CreditSpreads

Spreads appear related to credit risk

Source: JPMorgan.

At the expense of stating the obvious, one must relate spreads to one or more measures of credit risk inorder to make a generic valuation statement. In the context of illustrating the cyclical risks inherent inthe pricing of corporate bonds that we observe today, we ask the question: what sort of default andtransition rate scenario do spreads currently imply? We will seek to provide an answer to this questionusing JPMorgan’s ‘Rock Bottom’ spread framework. The basic premise for asking this question in thefirst place is the observation that spreads do not appear to be offering any sort of market liquiditypremium over and above what one requires to just offset the joint risks of default and transition, the so-called ‘Rock Bottom’ spread. That’s the case if we make the assumption that companies default nomore often than they have on average and, interestingly, the speculative default and downgrade rateshave recently fallen to their long-term averages. The reality, as my colleague Peter Rappoport haspointed out, is that calculated ‘Rock Bottom’ spreads are a function of their default and transition inputsand, when based on average default and transition rates, arguably overstate the ‘true’ level of credit riskthat we observe today. This is long hand for saying that we should calibrate for the current position ofthe credit cycle, both in terms of the outlook for default rates and the level of risk aversion.



109

��

-6.00

-4.00

-2.00

0.00

2.00

4.00

6.00

8.00

1980 1984 1988 1992 1996 2000 2004 2008E 2012E

% Dev. Ave. Default Rate Forecast Dev. Defaults

% Dev. Ave. Downgrade Rate Forecast Dev. Downgrades

Historical deviations 1980 - 2004 and long-term forecast 2004 - 2010

1993-97 and the repeat of a ‘Golden Age’

Source: JPMorgan estimates

Our approach is to initially consider the valuation implications of the sort of default and downgradeenvironment that we saw between 1993 and 1997. This, from a (recent) historical perspective, arguablyrepresents the best creditors might expect; a ‘Golden Age’, you might say, from a default anddowngrade perspective.

Of course, we might say that the 1993-97 period was very different; the credit market was highlybifurcated pre-EMU, corporate leverage was lower and what data we have suggests to us that spreadswere tighter, and things like shareholder pressure were yet to manifest themselves. Nonetheless, if weassume that we see a repeat of the 1993-97 period over the next 4-5 years, what we think this wouldmean is the default rate initially declining a full 5-6 percentage points below its long-term averagebefore mean reversion takes place.

Our empirical analysis shows that the elements of the rating transition matrix used in the ‘Rock Bottom’spread methodology are well correlated with two variables. The overall rate of downgrades explainsmost of the variance in high-grade transition probabilities, with individual correlations of around 80%.The speculative grade default rate, in turn, contains the most information about the variance in lowerratings’ transition probabilities. In consequence, we don’t lose much information by only focusing onforecasting these two parameters and translating these views into adjustments to the average annualtransition matrices and, as we’ve noted previously, the adjustments we make are based on theassumption of a full-blown re-run of the 1993-97 period. (This approach to re-calibrating default andtransition matrices is described in more detail in: Rock Bottom Spread Mechanics, Peter Rappoport, 25October 2001).



110

Credit cycle-adjusted ‘Rock Bottom spreads’ by sector

-30 -20 -10 0 10 20 30 40

Excess Spread in bp

Rock-Rock Bottom Excess Spread

Rock Bottom Excess Spread

‘Rock-’ versus ‘Rock-Rock Bottom’ spreads

Industrials

- Basic Industry

- Consumer Cyclical

- Energy

- Property & Real Estate

- Telecoms

- Transport

- Utilities

- Tobacco

- Technology

- Consumer Non-cyclical

- Media

- Capital Goods

- Autos

Rock-Rock RockBottom Bottom

Market Excess ExcessSpread Spread Spread

Industrials 45 8 0

- Autos 82 34 23

- Basic Industry 37 4 -4

- Capital Goods 40 15 9

- Consumer Cyclical 42 0 -10

- Consumer Non-cyclical 28 -2 -8

- Energy 51 13 3

- Media 34 -11 -20

- Property & Real Estate 48 7 -2

- Technology 14 2 0

- Telecoms 55 3 -6

- Tobacco 63 8 -6

- Transport 9 3 2

- Utilities 34 3 -3

Source: JPMorgan.

Euphemistically, we refer to these cycle-adjusted ‘Rock Bottom’ spreads as ‘Rock-Rock Bottom’spreads. From just offsetting average historical rates of default and transition, we observe that in ascenario in which the default and transition experience of 1993-97 repeats itself, market spreads todaycompensate an additional 8bp above what we have defined as ‘Rock-Rock Bottom’ levels.

We might debate whether the 8bp market liquidity premium that we observe today is correct givencurrent market conditions. It’s arguably lower than what we’ve typically seen on average, but this iswhere things start to look to us decidedly ‘grey’ rather than ‘black-and-white’. The liquidity premiummight itself be a function of where we are in the credit cycle and degree of visibility associated withfundamentals, and also things like the level of risk aversion and market technicals.



111

0

10

20

30

40

50

60

70

80

AAA AA A BBB

Spread in bp

Rock-Rock Bottom Spread

Rock Bottom Spread

Market Spread

0

10

20

30

40

50

60

1y - 3y 3y - 5y 5y - 7y 7y - 10y > 10y

Spread in bp

Rock-Rock Bottom Spread

Rock Bottom Spread

Market Spread

‘Rock-Rock Bottom’ spreads by rating ‘Rock-Rock Bottom’ spreads by maturity

‘Rock-Rock Bottom’ spreads by rating and maturity

Source: JPMorgan.

We’ve also calculated ‘Rock-Rock Bottom spreads by broad rating category and maturity bucket.

Where do we stand on valuations today? Our generic statement is that valuations look full, if not morethan full. In our view, the credit market is priced for a repeat of the ‘golden’ 1993-97 period. We mightalso think of this scenario in economic growth terms, as well as the deviation of the default rate from itslong-term average. Specifically, we might say that spreads today are priced for a repeat of the 1993-97in economic growth terms, which would imply US GDP growth running at real rates circa 3.5%-4.0%for the next 4-5 years. We don’t have forecasts that far out but, for what it’s worth, JPMorgan’seconomics team are forecasting full-year US GDP growth of 4.3% this year and 3.6% next year.



112

iTraxx main [bp]

20

25

30

35

40

45

50

55

60

65

70

Sep’03 Dec’03 Mar’04 Jun’04 Sep’04

600

800

1000

1200

1400

1600

1800

2000

iTraxx 0-3% tranche [bp]

DJ iTraxx main indexDJ iTraxx equity tranche spread [bp]

Levered versus unlevered credit… …their relationship and default correlation

0%

5%

10%

15%

20%

25%

30%

35%

40%

Jan’04 Apr’04 Jul’04

ATM Correlation

0%

1%

2%

3%

4%

5%

iTraxx / iTraxx 0-3% tranche

ATM CorrelationiTraxx spread / iTraxx 0-3% tranche spread

“Aren’t you simply trying to justify a ‘credit bubble’?”

Source: JPMorgan.

By way of playing devil’s advocate, one thought that crossed our mind is that we’re simply followingthe path to ruin that we saw in the equity market during the ‘bubble’ 1999-2000 period, simply trying tojustify ever-higher valuations or, in a credit market context, ever-tighter spreads. We hope we’re notdoing that. We’d also say that a significant difference between the credit market today and the equitymarket back in 1999-2000 is that it doesn’t appear to be pricing in a scenario in which default andtransition rates fall to new, all-time lows; a ‘golden’ scenario, yes, but a ‘credit bubble’, no, at least inour view.



113

Euro credit cyclical premium and the eurozone business cycle

35

40

45

50

55

60

65

Sep-04Sep-03Sep-02Sep-01Sep-00Sep-99

PMI

-50bp

-25bp

0bp

25bp

50bp

Cyclical Premium in bp

PMI (53.9)

Cyclical Premium (12bp)

Is the cyclical glass half-full or half-empty?

Source: JPMorgan.

We don’t have sector spreads going back to the 1993-97 period, but we do want to revisit the idea thatthe credit market is priced for 3.5%-4.0% growth over the next 4-5 years.

The cyclical premium is here defined as the asset swap spread differential between cyclical and non-cyclical Industrials. Currently, the premium stands around pick-up 12bp, and has been nudging widerrecently. This is higher than the longer term average of give-up 5bp and, from a business cycleperspective, a negative premium is not at all uncommon when the economy is expanding and, forexample, things like the composite Purchasing Managers’ Index are reading above 50.

Strip out the Auto sector, however, and it’s a different kettle of fish altogether. Excluding Autos, thecyclical premium is negative 2bp, slightly more generous than long-term average. What this means,metaphorically speaking, depends upon whether you think the credit market glass is half-full or half-empty. ‘The Full-ists’ would agree that cyclicals aren’t cheap, but make the case that they aren’t richeither with the premium essentially where it should be given the business cycle. ‘The Empty-ists’, onthe other hand, would cite the absence of a material cyclical buffer, or cushion, at a time when risks onthis front seem to be rising. Where do we ally ourselves? The answer is that the risk-rewardcharacteristics associated with the cyclical bloc look to us to be skewed asymmetrically against beingaggressively overweight, based on the current pricing structure.



114

Euro model portfolio active positions and active position changes November 2003-September 2004

-4 % -2 % 0 % 2 % 4 %

Utilities

Transport

Tobacco

Telecoms

Technology

Property & Real Estate

Media

Energy

Consumer Non Cyclical

Consumer Cyclical

Capital Goods

Basic Industry

Autos

Nov ’03

Sep ’04

-6 % -4 % -2 % 0 % 2 % 4 % 6 %

Public Sector

Financials

Industrials

-4 % -2 % 0 % 2 % 4 %

US Brokerage

Financial

Insurance Sub

Insurance Sen

Banks T1

Banks UT2

Banks LT2

Bank Senior

Nov ’03

Sep ’04

-10% -5% 0% 5% 10%

BBB

A

AA

AAA

The moral of the story is: be defensive

Source: JPMorgan.

The bottom-line from an asset allocation perspective is that we remain defensively positioned, but notunderweight within the context of our model corporate bond portfolio, and underweight the cyclicalbloc in particular.

Copyright 2004 J.P. Morgan Chase & Co.�All rights reserved.

JPMorgan is the marketing name used on global equity research issued by J.P. Morgan Securities Inc. and/or its affiliates worldwide. J.P. Morgan Securities Inc. (JPMSI) is a member of NYSEand SIPC. This presentation has been prepared for our institutional clients and is for information purposes only. Additional information available upon request. Information has been obtainedfrom sources believed to be reliable but J.P. Morgan Chase & Co. or its affiliates and/or subsidiaries (collectively JPMorgan) does not warrant its completeness or accuracy. Opinions andestimates constitute our judgement as of the date of this material and are subject to change without notice. Past performance is not indicative of future results. This material is not intended as anoffer or solicitation for the purchase or sale of any financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. The opinions andrecommendations herein do not take into account individual client circumstances, objectives, or needs and are not intended as recommendations of particular securities, financial instruments orstrategies to particular clients. The recipient of this report must make its own independent decisions regarding any securities or financial instruments mentioned herein. JPMorgan may act asmarket maker or trade on a principal basis, or have undertaken or may undertake an own account transaction in the financial instruments or related instruments of any issuer discussed herein andmay act as underwriter, placement agent, advisor or lender to such issuer. JPMorgan and/or its employees may hold a position in any securities or financial instruments mentioned herein.

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