The high yield bond market has been subject to extreme pressure since early last year, due mainly to commodity price weakness and potential defaults in commodity-related sectors. But at what point does enough become enough? Have spreads risen enough to potentially compensate investors for the risks in the market place? We believe the answer is "Yes".
Defaults Are Moving Up, but Spreads Today Can Compensate for Risk
With spreads1 of roughly 800 basis points (bps) over U.S Treasuries, the asset class is pricing in a default scenario typically reserved for recessionary environments. Even using a conservative assumption of a 5% default rate in 2016 (almost entirely a result of the fallout in the energy and metals & mining sectors), the implied 350 bps of credit loss (assuming a 30% recovery on defaults in the market) is well covered by the 450 bps in excess spread remaining (i.e., 800 bps in spread minus 350 bps in default loss). This is roughly 150 bps higher than the historical average premium (300 bps) that investors have demanded.
If anything, the financial positions of many companies have grown more conservative. Interest coverage generally remains strong, with EBITDA now up at 4.5 times interest expenditure and leverage at about 4.1x, down from a peak of 5.2x in the second half of 2009.2 There has been little sign of re-risking either: CCC-rated borrowers are accounting for just 10% of new issuance (compared with 30% in 2006-07), and 43% of new issuance is being used to refinance existing debt.
In short, we believe high yield fundamentals look reasonable, and valuations today are compensating investors for the default risk in the market.
Spreads vs. High Yield Default Rates
Source: J.P. Morgan, Moody's Investment Service; as of December 31, 2015.
1J.P. Morgan Default Monitor. Defaults based on par amounts.
2High Yield Spread to Worst is represented by the J.P. Morgan Global High Yield Index.
3Senior Floating Rate Loans Spread is represented by the Discount Margin (3-year life) of the S&P/LSTA Leveraged Loan Index.
Historically, Negative Years Have Been Followed by Gains
The U.S. High Yield Master II Constrained Index fell by 4.6% last year, and it bears noting that (although past performance does not guarantee future returns) the index has never experienced two successive annual declines.
High Yield Annual Returns
Source: Bank of America Merrill Lynch. High yield represented by Merrill Lynch U.S. High Yield Master II Constrained Index.
Overreaction to Current Challenges
What about current market pessimism? Spreads are signaling that the entire high yield market faces significant fundamental headwinds, which we do not believe to be the case. (The recent oversubscription of Pinnacle Foods (NYSE:PF) suggests there is market demand for issuance from quality businesses.)
In our view, excellent companies and robust industries have been indiscriminately punished in recent weeks, presenting active managers (and their clients) with superb opportunities to take advantage of dislocation in industries such as healthcare and gaming and navigate the broader market to avoid problematic credits. Refinancing is not an immediate issue for 90% of the market over the next couple of years, and only $69 billion (of a $1.3 trillion market) matures in 2016 and only $139 billion in 2017. Although we do forecast an increase in defaults in 2016-2017, we believe the majority will be concentrated in commodity-related sectors.
One concern that has been raised is around market liquidity. However, the notion that high yield is "not trading" is simply incorrect. Market turnover was 102% in 2015, consistent with where it has been over the last couple of years. Trading volume, on a daily basis, was on average $10.7 billion, up from $8.5 billion in 2014. There is a perception that ETF flows are apt to absorb liquidity from these markets, but investors should keep in mind that ETFs represent only $30 billion out of a $1.3 trillion market, or just 2.3% of the total assets.
For fixed-income markets in general, interest rate expectations tend to be a key topic of focus. However, for high yield investors, we believe the main focus should be on credit risk, not interest rate risk. High yield has historically exhibited negative correlation to U.S Treasuries, and tightening cycles have generally been positive for the asset class, as they usually represent a strengthening U.S economy. Over the past 20 years, there have been 16 such cycles, during which high yield spreads have typically tightened by about 73 basis points.
An Opportunity to Differentiate
We believe that episodic volatility should present active managers with the opportunity to properly differentiate between "winners and losers" in the market. When compared to ETFs, we think employing a well-resourced, conservatively-oriented active manager is a more prudent and effective means of accessing the high yield market.
Obviously, timing an "entry point" into high yield is difficult. Current market conditions remain highly volatile, and spreads have tended to peak at various stages of the default cycle, meaning that "calling the bottom" is almost impossible. Still, as compared to other risk asset classes, we believe the high yield market should provide an attractive risk/reward trade-off for the balance of 2016.
1Defined as spread to worst.
2J.P. Morgan. Data as of September 30, 2015, adjusted for one-time charges.
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