We usually like to see records. This summer's Olympics reminded us that seeing a performance that has never before been duplicated is uniquely special. However, not many investors feel great about the new record-low yields in speculative grade corporate bonds that were witnessed in late September.
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Even if you rode high-yield bonds as they outperformed the broad equity market gauge (see below) over the past three, five, and ten-year periods, concern over where to re-invest future bond coupons in this low-rate environment is disconcerting.
Source: Bloomberg, Barclays Capital, Standard and Poor's
Of course, high-yield bond returns are usually thought of in two separate components - the interest rate component equivalent to the matched duration Treasury bond, and the credit spread component that is compensation for the riskiness of the corporate borrower. While the sum of these two components is at all-time lows, credit spreads are closer to their long-run average as seen below. This highlights the titular conundrum facing fixed income investors. Do you continue to allocate funds to an asset class that is now paying investors less than ever before in a macro environment that remains fragile, or do you view the credit spread component as fair compensation for credit risk in this low default rate environment given the relative options in the fixed income universe?
Source: Barclays -Speculative Grade Corporate Bond Spread (b.p.)
Yes, it is difficult to invest in "junk" rated credit at an all-in yield of 6.5%. Just a little over five years ago, the Fed Funds rate was at 5.25%, and high yield savings accounts offered FDIC-insured yields with five handles. Yesterday's market is gone though. Investors need to determine if investing in high-yield corporate bonds today is prudent. Examining historic defaults relative to current credit spreads can provide investors with a clue about whether the credit markets are still offering ample compensation for risk.
As seen in the table below, the spread of the high-yield index at 556 basis points is still greater than the historic loss rate for speculative grade corporate credit of 274 basis points per annum experienced from 1982-2011. The current compensation for default risk is a decreasing function of credit quality, which is why despite lower yields, the relatively higher-quality BB segment of the high-yield market is still "The Winning Trade in High Yield Corporate Bonds."
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High-yield bonds are trading at relatively expensive levels to stocks. If you compare the earnings yield on stocks, as measured by the trailing twelve month earnings of the S&P 500 (SPY) divided by its index level, then speculative grade bond yields are trading at their largest premium to stocks on record. The graph below is the yield on the Barclays Capital High Yield index (replicated through the ETF JNK) minus the earnings yields on the S&P 500. Currently, the earnings yield on the broad equity gauge (6.8%) is greater than the yield on the bond index (6.5%). One can see below that the difference between the two yield measures shows high-yield bonds at their most expensive level relative to equities on record.
Source: Standard and Poor's, Barclays Capital
If you are concerned about going down in the capital structure from the debt to equity of a company, then perhaps another segment of the fixed income universe might offer attractive relative yields as well. Leveraged loans, like high-yield bonds, are also corporate debt instruments that are typically rated below investment grade. Leveraged loans, or bank loans, are typically arranged by one or more investment banks and syndicated to a group of commercial banks and other non-bank lenders. These bank loans are typically senior in the capital structure to bonds, and secured by the company's assets, ranking first in the capital structure in the event of bankruptcy. This priority is reflected in the higher recovery rates of loans versus bonds seen in the table below.
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The chart below graphs the dollar price of the S&P/LSTA Loan Index versus the bond price of the aforementioned Barclays High Yield index. The loan index is pricing at a lower dollar price than the high-yield bond index. This difference in price has led the yields to converge. Bank loan investors are now getting paid as much as investors in high-yield bonds, which are subordinate in the capital structure of a corporation and thusly offer lower recoveries in the event of bankruptcy. Part of the explanation for this anomalous phenomenon is the call-ability of bank debt. Since the issuer has the ability to pay the loan down at par, loan prices are capped by this negative convexity. While high-yield bonds are also often callable, it is at a price above par that slides discretely towards par as the bond nears maturity. With the entire high yield market now trading at a premium to par on average ($103.3), the price cap on leveraged loans necessitated by their par call has led to wider relative spreads on loans compared to bonds as bond yields have moved below their coupon.
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Retail investors interested in transitioning funds from high-yield bonds to leveraged loans have never had better opportunities. Several closed end funds and exchange traded funds now cater to this formerly institutional-only asset class. The Powershares Senior Loan Portfolio (BKLN), which launched in March 2011, is distributing roughly 4.9% to investors with the underlying loans yielding 6.2%. Blackstone and State Street are scheduled to launch the Senior Loan ETF (SRLN) in the near term. Leveraged loan closed end funds include: Eaton Vance Senior Floating-Rate Trust (EFR), Eaton Vance Floating-Rate Income Trust (EFT), Nuveen Floating Rate Income Fund (JFR), Nuveen Floating Rate Income Opportunity Fund (JRO), and Pioneer Floating Rate Trust (PHD). In the linked fact sheets, Seeking Alpha investors will see that each of these leveraged loan closed end funds pays a market distribution rate of 6.2% - 7.5%.
Investors seeking a historically low volatility asset class with embedded protection against rising interest rates should examine leveraged loans. Marrying a leveraged loan allocation, which is providing equivalent yields to high-yield bonds with what should be lower volatility, with investments in stocks, which will be more volatile than bonds but are priced at an historically attractive relative valuation, could lead to alpha generation relative to holding high-yield bonds alone.
Seeking Alpha investors should have three main takeaways from this article:
1) Junk bond yields are at historical lows given the reduction in interest rates, but credit spreads still provide adequate compensation for default risk, especially at the higher quality BB-rated end;
2) Speculative grade bonds are historically expensive relative to equities as the earnings yield on the S&P 500 now exceeds the yield on speculative grade credit;
3) Yields on leveraged loans will likely provide investors with better risk-adjusted returns than high-yield bonds given current equivalent yields and the likelihood of lower losses in the event of default on senior loans.
Disclosure: I am long SPY.