High yield shrugs off steep Treasury market rate increase
Let's take a quick look back at 2013 to set the stage for our 2014 outlook:
- Interest rates rose quickly following former Federal Reserve (Fed) Chairman Ben Bernanke's May comments about tapering.
- Valuations declined not only because of the inverse relationship between yields and prices, but also from technical pressure put on prices as money left the asset class.
- Six weeks of outflows after the tapering announcement were followed by a strong recovery in the high yield market, spurred by investors' interpreting the Fed's message to mean that the economy was doing well enough to allow withdrawal of liquidity from the system.
High yield differs from most other fixed income asset classes because high yield returns have historically had a negative correlation to U.S. Treasury returns. The Barclays U.S. High Yield 2% Issuer Cap Index returned 3.57% for the fourth quarter, which means the market fully absorbed the Treasury move in addition to some spread compression.
The high yield market's performance wasn't a surprise to us. It's been down only four times since 1980, and with each of those times was associated with a recession. Recessions - not rising rates - are the biggest threat to high yield markets.
High yield bonds may offer value
While macro headlines preoccupied investors during 2013, they largely overlooked improving fundamentals of the high yield market, including:
- Issuers experienced top-line growth.
- Earnings before interest, taxes, depreciation and amortization (EBITDA) rose faster than debt levels in the fourth quarter.
- Overall leverage of issuing companies trended lower.
- Default rates fell to six-year lows and are expected to remain low as all of the financing activity has dramatically lowered near-term maturities.
We believe that the amount of risk (default rate) being priced into the high yield market is currently overstated, which, in turn, leads us to believe that there is value in high yield bonds. In addition, supply and demand is supportive of the high yield asset class, in our view. The expectation for 2014 is a 15% decline in new issuance from last year's record of almost $400 billion, which provides positive technical underpinnings to the market when combined with the relatively low volume of maturities coming due in the next three years and the relative attractiveness of high yield compared with other fixed income asset classes.
Positive outlook for 2014
We believe high yield offers opportunity for investors, given the relatively high average coupon, low default rate and improving fundamentals of high yield issuers. In addition, the high yield market has responded favorably to the Fed announcement on gradual tapering, which is preferable to a more pronounced move. Although gross domestic product forecasts are on the rise, they are still within the 2% to 2.5% range that has historically been supportive for high yield, based on average returns dating from 1990 through 2013.
- JP Morgan High Yield and Leveraged Loan Outlook, July 2013, as measured by the Barclays U.S. High Yield 2% Issuer Cap Index.
- JP Morgan, Nov. 29, 2013 and Jan. 2, 2014
- Barclays. GDP rate is the quarter-over-quarter seasonally adjusted annualized rate (SAAR). Returns lag by one quarter. Past performance cannot guarantee future results. Returns from December 1990 - December 2013.
The JP Morgan Domestic High Yield Index is an unmanaged index of high yield fixed income securities issued by developed countries. The Barclays U.S. Corporate High Yield 2% Issuer Cap Index is an unmanaged index comprising U.S. corporate, fixed-rate, noninvestment-grade debt with at least one year to maturity and at least $150 million in par outstanding. Index weights for each issuer are capped at 2%. About risk: High yield bonds (junk bonds) involve a greater risk of default or price changes due to changes in the issuer's credit quality. The values of junk bonds fluctuate more than those of high quality bonds and can decline significantly over short time periods. Fixed-income investments are subject to credit risk of the issuer and the effects of changing interest rates. Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa. An issuer may be unable to meet interest and/or principal payments, thereby causing its instruments to decrease in value and lowering the issuer's credit rating.
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