Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Travel bonds: risky and expensive compared to junk bonds’ average
Althea Spinozzi
Head of Fixed Income Strategy
Summary: In this analysis, we look at the bonds issued by the companies listed in Saxo's Travel stocks basket. We find that travel bonds pay a lower yield and expose investors to bigger duration risk than the US junk bond's average. We also believe that recent trends in the credit bond market tell us that we are witnessing a duration event where longer maturities will be penalized over credit risk.
Amid the relentless rise in interest rates and inflation expectations, finding coupon income becomes even more crucial. Despite news report of a considerable amount of outflows from bond funds, the option-adjusted spread (OAS) of US investment grade and high yield corporate bonds remains nearly unchanged year to date. In contrast, their yield to worst (YTW), the lowest possible yield an investor would receive on a bond without defaulting, has risen slightly. The divergence between YTW and OAS in the credit space points out that any fall in price within the corporate space is mainly due to technical repricing over their benchmark. Still, the perception of risk has not changed. Looking at the US high yield corporate space, it is possible to note that the YTW has also barely moved, meaning that demand for riskier securities remains sustained despite US sovereigns continue to tumble.
The primary corporate bond market speaks for itself, indicating that it is not time to worry about a widespread selloff in the credit market because demand continues to be supported. Indeed, although last Wednesday the US high-grade bond issuance paused for a day, the successful issuance of Verizon’s jumbo bond deal on Thursday has revived corporate bond supply. However, it is important to note that high-grade corporate bonds are at a much greater risk of repricing due to their extremely heavy duration, making these securities more sensitive to changes in interest rates. As a matter of fact, while US investment-grade corporate bonds offer an average of 2.2% in yield for a duration of 8 years, the high yield bond market can offer double the yield for less than half the duration, just 3.5 years.
While we might see some signs of tiredness in the investment-grade market, this sentiment is yet not leaking to the high yield bond market for the simple reason that junk is the only asset that enables investors to lock in a yield higher than inflation expectations minimizing duration. This month, US Junk bonds are just $9 billion shy to break the monthly record issuance ever recorded. So far, around $27 billion were already sold in the month of March. On top of it, junk bond issuers can tighten spread significantly during the selling process as demand continues to be elevated.
It is becoming clearer and clear that we are witnessing is a duration event, which penalizes long maturities over credit risk.
The travel business's recovery turned investors' attention in recent weeks, especially in the United States. Indeed, as the vaccination pace is picking up, it is possible to expect people to resume moving freely across nations contributing to this sector's fast recovery.
My colleague Peter Garnry has put together a portfolio of 40 travel stocks, which have rebounded significantly in the past few months. Peter rightly points to the fact that current stock valuations in the travel business are approaching the highest levels since late 2015, reflecting strong expectations for profitability which may or may not materialize depending on the recovery's nature. Although the travel bond sector had also recovered since the lows of March last year, some of the bonds within these space offer a yield higher than average. To give you an example, TripAdvisor’s bonds offer a yield of around 3.5% for an average duration of one year and a half. Compared to the US high yield’s corporate average, TripAdvisor’s notes enable to reduce duration significantly while still securing a juicy yield.
In the list below, I look at the average yield and duration that notes issued by Peter’s travel basket’s companies offer. It emerges that, on average, travel bonds have a duration of around 4 years and offer around 3% in yields. It translates to the fact that travel bonds pay lower returns and expose investors to bigger duration risk than the US junk bond average.
At this point, we believe that bonds of the travel sector don’t provide an adequate return compared to the risk that they expose investors to. The biggest risk stems from unequal recovery testing companies, which have lost nearly a full year of revenues. Economic recovery can be exponential; however, travel companies’ capacity will continue to be constrained. Indeed, there are only that many rooms and seat a hotel or airplane company will be able to fill. Therefore, while the upside is limited, the downside is big and can lead to default.
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