Worried About Downside Scenarios? These Are Goldman's Top Credit Hedges For A Prolonged Shock

Despite the ongoing conflict in Iran and resulting elevated oil prices and tighter financial conditions, most risk asset markets have (so far) not priced in much durable additional risk premium.

In equity markets the S&P 500 still sits just 3.8% off its all-time high, and in credit markets, USD investment grade and high yield bond indices are just 6bp and 19bp wider, respectively, since February 27th, still well within the bottom historical quintile. 

For context, in the two months leading up to the 'Liberation day' tariff announcements last year, IG and HY spreads widened by 37bp and 190bp, respectively.

While Goldman Sachs economists are so far forecasting a relatively limited economic impact, for those investors worried about a prolonged conflict or energy prices remaining higher-for-longer, Goldman's credit team recommend three hedges for US corporate credit investors that remain attractive within that context...

We recently upgraded HY Energy to neutral from underweight on the back of the onset of the Iran conflict and subsequent move higher in oil prices, given our base case of a relatively limited episode.

To hedge the tail risk of crude oil remaining higher-for-longer we think investors could take this view one step further and go overweight the HY Energy sector vs. the broader HY ex-Energy index.

 Exhibit 1 shows that the spread differential between HY Energy vs. the rest of the index is currently trading at -86bp, still at the 19th percentile vs. a history of the last 10 years, with room to move tighter if crude prices stay at or near current levels.

Exhibit 1: HY Energy excess spreads have room to move tighter given the magnitude of the move in crude prices

Spread differential between USD HY Energy vs. the rest of the HY index compared to WTI crude prices

Source: Bloomberg, Goldman Sachs Global investment Research

For investors worried that financial conditions will tighten further, impacting the broader economy and challenging growth and inflation projections (again, not our base case), we think it makes sense to buy protection on CDX or CDX HY to hedge against a broad move wider in credit spreads. 

Exhibit 2 shows that spreads on the CDX index have not yet moved wider commensurate with the move higher in implied volatility on the index. For context, 3-month at-the-money forward implied vol on the CDX index is currently at the 80th percentile vs. the last 10 years while the spread is only trading at the 43rd percentile.

Exhibit 2: CDX spreads have not moved wider commensurate with the move higher in implied vol

CDX 5y spreads vs. CDX 50-delta 3m implied vol

Source: Goldman Sachs FICC and Equities, Goldman Sachs Global investment Research

Another effective way that investors could hedge against a larger rebuild in credit risk premia would be to overweight Agency MBS vs. IG corporates (Exhibit 3).

Although our current view is to be neutral between Agency MBS and USD IG corporates, we believe this would position against a further weakening in risk sentiment.

As our structured products colleagues recently noted, with IG spreads likely to widen in a risk-off rate rally scenario, we believe the prepay-protected agency MBS specified pools offer attractive diversification benefits to an IG corporate portfolio.

While weaker economic conditions would likely lead to widening pressure in corporate bonds, agency MBS spreads could benefit from the backstop provided by the $200 billion GSE program, as well as from healthy fixed income fund inflows.

We would also note that the Bloomberg MBS index typically outperforms the IG corporate index during months when IG spreads have widened by at least 5bp.

Exhibit 3: We think Agency MBS offers attractive diversification benefits to an IG corporate bond portfolio in a sell-off scenario

Agency MBS current coupon basis vs. USD IG OAS

Source: Bloomberg, Goldman Sachs Global investment Research

Tl;dr:

• To effectively hedge against a potential broad risk sell-off, we recommend buying CDX/CDXHY protection as spreads have not yet widened commensurate with the move higher in implied volatility in index swaptions.

• For investors concerned about higher-for-longer crude oil prices, we recommend an overweight on HY Energy vs. the broader HY index.

• Agency MBS could also offer an attractive diversification benefit vs. a portfolio of IG corporate bonds. We find that MBS typically outperforms the IG corporate index during months when IG spreads have widened by at least 5bp.

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