Does High Yield Make Sense in Today’s Environment?
High-yield bonds began 2017 yielding 6.5% with spreads at what were then at a 27-month low of 476 basis points (bps).1 It’s unclear whether investors became nervous about the specter of potential rate hikes, coupled with relatively tight spreads, but subsequently, the asset class saw outflows. Almost six months later, as of June 19, spreads have tightened further to 436 bps, and the high-yield market (as represented by the BofA Merrill Lynch US High Yield Master II Index) is up 5.05% year-to-date, outperforming both core bonds and leveraged loans. 1,2,3
For those wondering how high yield can potentially still generate competitive performance in a rising rate environment with tighter-than-average spreads, there are a few important concepts to keep in mind.
Below-Average Spreads Can Stay Low for a While
Default Rates vs. Spreads
Source: J.P, Morgan, May 1997 – June 2017. Note: Default rates are par-weighted. High-yield bond spreads use the JPMorgan Domestic HY Index. The JPMorgan Domestic High Yield Index measures the performance of high-yield bonds. It is not possible to invest directly in an index. Past Performance is not indicative of future results.
Spreads and Defaults Below Averages, with Solid Fundamentals
First, spreads are the market’s way of pricing credit risk and the probability of default, and they tighten based upon investor risk appetite and the perceived creditworthiness of issuers. With a default rate of 1.3%, it makes sense that spreads are below historical averages.1 Expanding on the notion of credit risk, fundamentals overall are very good. Year-over-year revenue growth has improved for the fifth consecutive quarter, led by the energy sector’s 31% improvement.2 Close to 47% of the high-yield market is rated BB (up from 36% in 2008), which means higher-quality paper is coming to market.
Issuers have decent cash balances, and leverage ratios are not alarming. New issuance this year has been predominantly refinancing activity, which means companies are lowering the coupon on their debt, while pushing out the maturity wall. Typically, as the above chart shows, when you get this far into a recovery cycle and spreads get below their average, they can stay there for a while. Past performance is not indicative of future results.
A Coupon-Clipping, but Still Good, Yield
Second, let’s take in the eponymous nature of the asset class: high yield does, in fact, generate a relatively high yield. Despite Fed hikes which have increased rates on the front end of the curve, the 10-year Treasury yield has actually declined from 2.45% at the start of the year to 2.19% on June 19. For investors seeking income, we believe high yield remains an attractive option, as the chart below demonstrates.
Source: Bloomberg, as of 5/31/17. Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index. Global Aggregate = Bloomberg Barclays Global Aggregate Index; U.S. 10-Year Treasury = Bloomberg Barclays 10-Year Treasury Index; U.S. Aggregate = Bloomberg Barclays U.S. Aggregate Index; U.S. Investment-Grade Corp. = Bloomberg Barclays U.S. Corporate Investment-Grade Index; European High Yield = BofA ML European High Yield Index; Emerging Markets Sovereign (USD) = BofA ML EM External Sovereign Index; Emerging Markets Corporate (USD) = BofA ML EM Diversified Corporate Index; U.S. High Yield = BofA ML U.S. High Yield Master II Index.
In early 2016, when there was a risk-off sentiment in the market and spreads were much wider, there was greater perceived credit risk, and as such, investors who took that risk were rewarded with significant total returns. As a result of rising equity markets, lower interest rates, and downward trending volatility, U.S. high-yield spreads have narrowed to levels consistent with periods of stable U.S. economic conditions. In today’s market environment, spreads are indicative of more favorable credit conditions that provide investors with less opportunity for outsized gains. Consequently, investors may see more of a coupon-clipping-type return, which is still a very good coupon, compared with other instruments.
Being that high-yield bonds are more credit sensitive than interest-rate sensitive, credit fundamentals are more of a driver of performance than moves in U.S. Treasury yields. We believe that, rather than rising interest rates, investors in the high-yield market may want to pay attention to credit metrics and the behavior of issuers. For example, when there is an uptick in leveraged buyout (LBO) activity and lower-quality paper in the new issuance market, or issuers increase their leverage, credit conditions may be deteriorating. However, given where these indicators stand today, in our opinion, spreads are prone to remain range-bound for some time, potentially providing attractive levels of income to investors.
1. J.P. Morgan, June 2017.
2. Bank of America/Merrill Lynch, June 2017.
3. Core bonds represented by the Bloomberg Barclays U.S. Aggregate Bond Index; Leveraged loans represented by the S&P/LSTA Leveraged Loan Index.
High-yield securities carry higher risks and some of the Fund’s investments have speculative characteristics and present a greater risk of loss than higher-quality debt securities. These securities can also be subject to greater price volatility.
A bond’s prices are inversely affected by interest rates. The price will go up when interest rates fall and go down as interest rates rise. Bonds are subject to credit risk and interest rate risk.
There is no guarantee that any forecast made will come to pass. This material does not constitute investment advice and is not intended as an endorsement of any specific investment.
Basis points (BPS) refer to a common unit of measure for interest rates and other percentages in finance. One basis point is equal to 1/100th of 1%, or 0.01% (0.0001), and is used to denote the percentage change in a financial instrument
The BofA Merrill Lynch Euro High Yield Index tracks the performance of Euro denominated below investment grade corporate debt publicly issued in the euro domestic or eurobond markets.
The BoA Merrill Lynch EM External Sovereign Index tracks the performance of U.S. dollar emerging markets sovereign debt publicly issued in the U.S. and eurobond markets.
The BoA Merrill Lynch EM Diversified Corporate Index is designed to measure the performance of U.S. dollar-denominated emerging markets corporate senior and secured debt publicly issued in the U.S. domestic and Eurobond markets.
The BoA Merrill Lynch U.S. Cash Pay High Yield BB-B Rated 1-5 Year Index is a subset of the BoA/ML U.S. Cash Pay High Yield Index including all securities with a remaining term to final maturity less than 5 years and rated BB through B inclusive.
The BofA Merrill Lynch U.S. High Yield Master II Constrained Index is a market value-weighted index of all domestic and Yankee high-yield bonds, including deferred interest bonds and payment-in-kind securities. Issuers included in the index have maturities of one year or more and have a credit rating lower than BBB-/Baa3, but are not in default. No single issuer may constitute greater than 2% of the Index.
The BofA Merrill Lynch U.S. High Yield Master II Index is tracks the performance of U.S. dollar-denominated below investment-grade corporate debt publicly issued in the U.S. domestic market.
The Bloomberg Barclays 10-Year U.S. Treasury Index is a universe of Treasury bonds, and used as a benchmark against the market for long-term maturity fixed-income securities.
The Bloomberg Barclays Global Aggregate Index is a flagship measure of global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
The Bloomberg Barclays U.S. Corporate High Yield Index is a market-weighted index that includes publicly traded bonds rated below BBB by S&P and Baa by Moody’s.
The Bloomberg Barclays U.S. Corporate Investment Grade Index is a market-weighted index that includes publicly issued US corporate and specified foreign debentures and secured notes that meet the maturity, liquidity and quality requirements.
The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment-grade, U.S. dollar-denominated, fixed-rate taxable bond market, including Treasuries, government-related and corporate securities, mortgage-backed securities (agency fixed-rate and hybrid adjustable-rate mortgage pass-throughs), asset-backed securities, and commercial mortgage-backed securities.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
The S&P/LSTA Leveraged Loan Index is a broad index designed to reflect the performance of U.S. dollar facilities in the leveraged loan market.
Risk Premia is the difference between the expected return on a security or portfolio and the “riskless rate of interest” (the certain return on a riskless security).
A yield curve is a curve on a graph in which the yield of fixed-interest securities is plotted against the length of time they have to run to maturity.
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