By George Peller, Director of Research at Hanlon Investment Management
High yield bonds were one of the best performing asset classes in 2016, trailing only small blend U.S. equities (Morningstar U.S. Small Cap TR Index =20.25%, Bank of America HY Master II TR Index = 17.49%).
Of course, past performance is no guarantee of future success, and the consensus is that investors should temper their expectations in 2017. Many analysts have taken a much more bearish tone, warning that high yield bonds have reached extremely overvalued levels. Calls for a correction have persisted since February.
A common argument for reducing high yield exposure is that spreads are below historic averages, and therefore a reversion to the mean is going to occur at any moment.
Despite the warning signs and a 2.25% pullback in March as oil prices fell below $50, and a recent 1% drawdown due to geopolitical tensions with North Korea, high yield has slowly and steadily advanced in 2017. Year to date, through Oct. 18th, high yield bonds have returned 7.30%, an annualized rate of 9.33%, as measured by the Bank of America Merrill Lynch U.S. High Yield Master II Index (BofA HY Index).
Where do high yield bonds go from here? One could easily make a bullish or bearish case due to the large number of factors at play. Let's review the arguments for and against at current valuations.
Defaults are low: Many of the toxic high yield energy holdings from 2016 have dropped off the trailing 12 months (TTM) default calculations. As a result, the TTM high yield default rate has fallen below 2% for the first time since March 2014. In 2015 to early 2016, the BofA HY Index drew down over 13% due to fears that energy firms would default en masse and drag down related sectors, such as financials. A year and a half later, energy is no longer a major concern, despite sub-$50 oil prices. We're keeping a close eye on the retail sector (discussed in "Bearish" below), which is showing signs of stress. At just 3% of the high yield universe, the impact of a retail meltdown would likely be contained.
Ratings indicate improving health: Year to date, Standard & Poor's has issued 231 upgrades and 329 downgrades, an Up/Down Ratio of 0.70. In 2016, when high yield bonds gained over 15%, the ratio was 0.41, with 273 upgrades and 671 downgrades.
The same trend can be seen in the count of Fallen Angels (investment grade bonds downgraded to high yield status) and their counterparts, known as Rising Stars (high yield bonds upgraded to investment grade). In 2016 there were 59 Rising Stars and 37 Fallen Angels, a ratio of 1.59. Year-to-date there have been 32 Rising Stars and 11 Fallen Angels, a 2.91 ratio. So, yes, spreads are at their lowest levels since 2014, but the Up/Down ratio is at its strongest level since then as well.
Yield is in demand: One of the reasons that high yield spreads have remained stubbornly low is the lack of other options for investors seeking yield. The Bank of America Merrill Lynch Euro High Yield Index (BofA Euro HY Index) yields just 2.36% compared to the 5.61% yield on its U.S. counterpart, prompting foreign investors to seek out US-denominated corporate debt. Until the European Central Bank begins aggressively reigning in its stimulus measures, foreign demand for U.S. debt will persist.
The U.S. economy is healthy: High yield bonds are unique in the fixed income landscape due to their high correlation with equity markets. In many ways, high yield bonds reflect the health of the economy, which, at the moment, is good per most indicators. Few would argue that the U.S. is at risk of a recession. With low unemployment and rock-solid earnings, there's little reason to expect a widespread uptick in corporate defaults. Given the dysfunctional state of Washington, it's far from certain that any of President Trump's economic or tax reforms will see the light of day. Even if none of his campaign promises pan out, the economy appears to be on stable footing.
High yield bonds typically mirror equity markets more closely than fixed income markets.
Beware retail and telecom: As noted in the "Bullish" section above, the retail sector is a weak point in corporate debt markets. Retailer defaults could rise from a TTM rate of 2.9% to 9% if several larger borrowers such as Sears Holdings (SHLD) default this year. While oil prices have stabilized in the range of $45-$50 a barrel for US West Texas Intermediate, any sustained dip below $40 could put pressure on some of the weaker drillers. More troublesome, telecom debt has started to show signs of weakness. Sprint (S), with a 2-to-1 debt-to-equity ratio, has been unable to secure a merger with T-Mobile (TMUS) or Charter Communications (CHTR). Windstream Communications (WIN), with roughly $5.5 billion in high yield debt, recently suspended its dividend, prompting its bond prices to fall. A look at the sector exposure in the iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG) reveals a 25% concentration in telecom, so even a moderate uptick in telecom defaults could do some damage to the broader high yield market.
Beware poor covenant protection: The trend has been for newly issued bonds to provide investors with fewer and fewer legal protections, known as covenants. Bond covenants typically establish maximum debt-to-earnings or minimum interest coverage ratios. Moody's tracks the quality of bond covenants in the high yield market via its Covenant Quality Index. The data clearly shows that investors have been willing to forego the protection measures afforded to them in the past. The North American Covenant Quality Index for July hit 4.49, within three basis points of the worst score ever, set in August 2015. For reference, 5.0 is the absolute worst possible score and 1.0 is the best. The rise of "cov-lite" debt could lead to much lower recovery rates for bond investors. Negative events that in the past would have triggered a default event are now permitted, allowing firms to overextend their borrowing.
ETFs increase volatility and speculation: The proliferation of exchange traded funds ETFs and their impact on the high yield bond market has been a subject of much debate over the past decade. There's no doubt that high yield bond ETFs have improved liquidity and opened the asset class to a much wider range of investors across the globe. These ETFs have faced several tests and performed admirably. On the flip side, the rise of the ETF has also increased volatility and speculation, by allowing investors to add and remove exposure on a whim. Since ETFs only hold a representative sample of the high yield universe, the result is increased volatility compared to, say, the Bank of America High Yield Index, which contains a much larger number of illiquid positions. We've seen high yield investors rush to the exits in the past, and money that has been parked in the ETFs could easily be reallocated in the event of a major economic or geopolitical event.
The Fed: The Fed's comments and actions have triggered market selloffs in the past, and we shouldn't rule out the possibility of it happening again. For years, investors fretted over the impact of Fed rate hikes. Having absorbed four of them, hikes have become a non-issue for the markets. One could argue that for high yield bonds, with their lower duration risk, it never was much of an issue. The new concern is the impact of the Fed unwinding its $4.5 trillion balance sheet, and how it will impact the markets. While the Fed doesn't own high yield corporate debt-its balance sheet is composed mostly of Treasuries and mortgage-backed-securities-high yield markets could be affected. As the Fed stops buying bonds, yields on Treasuries and investment-grade debt may rise to levels that entice investors to rotate out of high yield. One thing to keep in mind; the amount of money that the Fed needs to divest is massive, and it could take decades to complete. Further, the lack of inflation data has evidently given some Fed members reason to pause, so we could see a more dovish Fed as we close out 2017.
Don't Throw in the Towel
Analysts have been calling for a high yield correction since at least February, and those calls will likely persist through the end of the year if spreads remain in the current range. While some support their positions with valid arguments, others may simply be looking to get "on record" calling a top because historical data suggests a reversion to the mean is likely at some point. I'm reminded of 2011, when many investment professionals touted shorting Treasuries as the no-brainer trade of the decade. The rationale behind the call was that Treasury yields were historically low; therefore, they couldn't possibly go lower. We all know how that trade panned out.
High yield spreads are below historical averages. It's entirely possible that high yield bond prices continue to grind higher for the remainder of 2017. The economic indicators, default rates, and rating actions are not flashing warning signs yet. Until they do, there's no reason to throw in the towel on high yield bonds.
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