It has been a whirlwind two months for the high yield corporate bond market. This article seeks to distill down the current opportunity set for Seeking Alpha readers.
- December 2018 produced the worst monthly return (-2.1%) in three years during the commodity-related sell-off in late 2015.
- January 2019 produced the best monthly return for high yield debt in more than seven years (+4.5%) - since the October 2011 bounce back from credit stress related to the U.S. downgrade and rolling European sovereign debt crisis.
- While the "junk bond" market is a derisive nickname for below investment grade credit, the senior nature of debt in a company's capital structure has led the high yield corporate bond market to have less than 60% of the variability of the broad equity market. It has been a historic two-month ride for high yield bonds, but that paled compared to the swing in equities. The lower volatility nature of high yield bonds was demonstrable as the S&P 500 sold off by 9% in December.
- These market moves leave the current yield-to-worst of the Bloomberg Barclays U.S. Corporate High Yield Index at 6.89%. With no credit losses from bond defaults, this would be the return that holders of a diversified portfolio of high yield corporate bonds would expect to earn over the 5.8-year average life of the index.
- The current credit spread over Treasuries of the high yield corporate bond market is 440 bps, which can be viewed as compensation for credit risk. I view this as more than fair compensation for default risk even giving credence to the fact that we are likely later in the credit cycle. At a 40% historical recovery for senior unsecured debt in the event of default, the high yield bond market is pricing in a 7.3% annual default rate.
- At the outset of 2019, I was fairly constructive on risky assets and called for a return slightly above the bond coupon (6.4%) for high yield debt. With the high yield corporate bond market already returning 4.8% this year, upside might be limited to low single-digit returns from here over the next three-plus quarters.
- As I indicated in an accompanying piece - The Junk Bond Bounce & Other Takeaways - the December-January time period typically delivers one-third of annual returns. Above trend returns in this time period have to lead to below trend returns in other months, a trend that I view as likely to repeat over the course of 2019.
- Where would outsized returns come from in high yield credit? The CCC rated segment of the market yields 11.2%. With the single-B index yielding just 7%, strong returns from high yield corporate debt would need to come from the lowest rated credits.
- The highest rated cohort of speculative grade debt, bonds rated BB, now yield just 5.27%. While this higher rated segment has delivered higher total returns historically - a cousin of the low volatility trade in equities - there is limited upside with spreads of around 277 bps over Treasuries.
- At $1.2 trillion, the high yield corporate debt market is now less than half the size of corporate debt rated BBB, the lowest rung of investment grade. Outsized growth in investment grade credit, and the growing bank loan market crowding out some high yield issuance, has made BBB debt outstanding soar relative to high yield debt. How the high yield corporate bond market absorbs credit downgrades from investment grade might be a large driver of its performance through the cycle.
I hope these ten facts help frame the current opportunity set in the junk bond market.
Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.