Credit Cracks

Recent performance in credit, both investment-grade and high-yield, has been steadily positive since the stock market bottomed in early March. Some of this was due to a legitimate decrease in systemic risk as well as a mildly improved economic picture. But now credit looks extremely overbought, and investors would be wise to temper their expectations for further outsized gains.

The chart below shows the price-only return (i.e., no coupon income) of the Merrill Lynch High Yield Master index for the last year (blue) along with the 75-day rolling average (red). I've also included a standard RSI calculation in green. Note that the investment-grade market shows a similar pattern if you control for general interest rates.

High Yield Merrill Lynch

Paired with the overbought signal are a few new cracks in the credit markets; some recent new issue corporate bonds have been performing poorly. Dow Chemical (DOW - commentary - Trade Now) sold 10-year bonds on May 7 at a spread of 525 basis points (bps), or 5.25 percentage points, over Treasuries, now the spread is over 600bps -- wider (higher) spreads indicate weaker prices. CBS (CBS - commentary - Trade Now) sold 10-year bonds the next day at a spread of 596bps; now they sit at 670bps. Even less cyclical names have posted mediocre post-issuance performance. Anheuser-Busch InBev sold 10-year bonds on May 11 at a spread of 375bps; they are 390bps above Treasuries now. Most of the recent new bank issues are either modestly tighter or unchanged.

Granted, 15bps wider on InBev bonds isn't the end of the world, but it's the exact opposite of what buyers had been expecting. Until this week, new-issue corporates have been almost universally moving tighter immediately after issue. For example, Potash (POT - commentary - Trade Now) sold 10-year bonds on April 28 at a spread of 350bps. After issuance, the bonds moved tighter rapidly, by April 30 the bonds were trading around 290bps, a nearly 4-point gain.

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At the time of publication, Cavanaugh Capital Management was long LQD and Graff was personally short JNK, although positions may change at any time.

Tom Graff is a managing director of Cavanaugh Capital Management, a registered investment adviser in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.