By Jennifer Ponce de Leon, Senior Portfolio Manager and Head of High Yield
High yield has become a very bifurcated market with few issues trading at or near market median. Energy, metals and mining companies are under significant pressure, yield significantly more than the index, but face the prospect of very high defaults in the next two years. The non-commodity-related high-yield universe has widened in sympathy, mostly trading at yields well below the index, but offering much better risk-adjusted opportunities with lower default prospects. We believe that a 7% yield premium (+700 basis points vs. Treasuries) excluding the troubled energy, metals and mining industries is an attractive entry point. This provides an extra 2% yield cushion to long-term averages for investing in high yield. The market is now approaching this level as the selloff in high yield has broadened beyond energy, making core high yield (ex. commodities) more attractive.
2016 continues to offer investors largely the same set of challenges as 2015. However, this year had a different valuation starting point for high yield, which provides additional compensation for these risks. Absolute returns will largely depend on two factors:
- the resiliency of the U.S. economy and the feedback loop of stalled out global growth, and
- the market's reaction to deviating central bank policies and less aggressive capital markets
We would note that the second factor could lead to greater caution by company management teams and the resulting impact on corporate growth. However, some relative return opportunities are beginning to emerge. We remain cautious of the risks facing the asset class, but constructive on much of the non-commodity-related high-yield opportunity set. Credit fundamentals remain adequate and support the asset class with reasonable earnings growth, low default rates, access to capital at reasonable rates and solid-yet-contracting enterprise value multiples underpinning debt levels.
Also, history has shown that the high-yield market has not experienced back-to-back negative annual total returns. However, there have been modest return years sequentially during uncertain environments, the most relevant example being the 2000 to 2002 period (Exhibit 1). Finally, we continue to view high yield as attractive relative to equities, especially since high-yield companies generate a greater proportion of their revenues in the U.S. and are pricing in more weakness. But for all of our analysis, we reinforce caution on the higher beta part of the market and do not believe this is the time to stretch for return or reach for yield by adding significant risk to the portfolio in the most troubled industries or lowest quality rungs.
Exhibit 1: High yield has not experienced back-to-back negative annual returns
Source: J.P. Morgan, as of December 31, 2015.
Relative value opportunities
Although there are risks to the downside, we believe current valuations in the asset class have priced in many of these risks. As of January 20, 2016, valuations for the high-yield market according to the Merrill Lynch U.S. High Yield Cash Pay Constrained Index are at 9.69% yield to worst (YTW) and +819 bps spread to worst (STW). Yields are higher by 101 bps and spreads are wider by 130 bps since December 31, 2015 and have reached levels not seen since October 2011, when yields and spreads peaked at 9.85% and +875 bps, respectively.
Excluding energy/metals/mining sectors, spreads are at +680 bps, for a yield of 8.30%, which is approximately 180 bps wide of the historical median of 500 bps. This highlights the continued importance of calibrating index valuations excluding the two components impacted by weaker commodity prices.
Based on historical risk premiums, high yield is now pricing in a 7.6% default rate in 2016 vs. our expectations for a 5.5% default rate. The non-commodity related "core" of the market is pricing in a 6.0% default rate vs. our expectations for a sub-3.0% default rate.
Exhibit 2 & 3: Valuations providing additional compensation for risk
High Yield: Spread to Worst
High Yield: Yield to Worst
Relative to equities, the high-yield market appears to be pricing in additional compensation for the risks being faced today. While high-yield bond spreads are approaching levels last seen in 2011, when the market was pricing in a global recession, the S&P 500 has retreated to levels seen in August/September 2015 and remains only 11% below its all-time high.
Exhibit 4: Is high yield pricing in more weakness than equities?
High Yield: Spreads vs. S&P 500
Technical factors: Flows and supply
Technicals, while mixed, continue to support the asset class. High yield saw a third consecutive year of outflows in 2015 and this trend has continued into 2016. The outflows are partially offset by lower issuance, which is expected to continue to decline in 2016 as we believe there will be fewer opportunistic refinancings taking place given higher market rates and tighter underwriting standards.
High-yield bond maturities remain manageable over the coming years given the amount of refinancing that took place over recent years as management teams took advantage of historically low interest rates. Only 15.5% of high-yield bonds and leveraged loans mature within the next three years compared to approximately 22% at the end of 2011.
Exhibit 5: Manageable maturities in the high-yield market
High Yield Bond & Loan Maturity Schedule
Given the reasonable fundamentals, limited refinancing risk, low overall levels of leverage and reasonable earnings outlook, we still view high yield as an attractive investment alternative to equities. We continue to be cautious on the higher beta part of the market. As a result, we do not believe this is the time to stretch for return or reach for yield by adding significant risk to the portfolio.
By positioning for stable and improving credit situations, avoiding credits with deteriorating fundamentals, and remaining disciplined in terms of getting paid for taking risk, we believe active managers can generate solid risk-adjusted returns in 2016. A disciplined credit selection process based on strong fundamental analysis and rigorous risk management should serve investors well in taking advantage of opportunities that have been pulled down with the overall market.
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