High-Yield Fundamentals: Still Solid
Investors looking for income may still find what they need in U.S. high-yield bonds. As long as issuers’ fundamentals remain fairly constructive, which we believe to be the case, high yield may continue to offer investors an attractive yield, with a relatively short duration and less interest-rate sensitivity than other fixed-income asset classes. The U.S. high-yield default rate stood at 1.21% at the end of July, while recovery rates increased to 45%, which is 4% above their 25-year long-term average.1 Looking at the high-yield market in aggregate, leverage ratios are fairly muted – that is to say that they are not exorbitant as they were at the end of the last credit cycle.
Additionally, as Figure 1 below illustrates, since the financial crisis, leveraged buyout (LBO) issuance has been fairly minimal. This is significant because LBO issuance is an indicator of the level of risk issuers are taking, in order to access the high-yield market. Leveraged buyouts involve the acquisition of another company using borrowed capital, so when LBO activity increases, overall leverage in the market tends to increase as well. Further, new issuance use of proceeds continues to be led by refinancing, which means companies are lowering their interest expense, while pushing out the maturity wall, both of which are viewed as favorable by investors.
Figure 1: New Issuance Is Not Relying on New Risk
LBO and Refi Percentage of New Issuance
Source: JP Morgan, 1/17. Leveraged Buyout (LBO) is the acquisition of another company, using a significant amount of borrowed money (bonds or loans) to meet the cost of acquisition. Chart created by New York Life Investment Management. Past performance is no guarantee of future results, which will vary.
Some investors have expressed concerns about spreads, which as of 8/15, were at 450 bps, as per JP Morgan. So yes, spreads are tight, but this is consistent with prior periods of stable U.S. economic conditions. Moreover, it would be remiss to talk about spreads without looking at the default rate, which is well below historical averages. Viewing spreads in tandem with the default rate leads us to believe that the spread-to-default relationship is adequate and credit risk is fairly priced.
While investors should consider that when high-yields spreads tighten they have historically remained range-bound for some time, it is also important to consider rationale for the tightening. We discussed the low default rate and favorable credit fundamentals, but there is another factor at play – the credit quality of new issuance. In Figure 2, we compare the credit quality of new issuance in 2007 vs. the period since 2013. New issuance over the last few years has been characterized by markedly higher-quality paper, helping to shift the overall credit quality breakdown of the universe. The BofA Merrill Lynch U.S. High Yield Index is now comprised of 48% BBs (on a par value basis), up from 36% at the end of 2008. The largest high-yield issuers are generally large, publicly traded companies. In fact, 62 of the 100 largest issuers are part of the Russell 1000 Equity Index.
Figure 2: Higher-Quality Paper Is a Factor in Tighter Spreads
Credit Quality of New Issuance
Sources: JP Morgan, JP Morgan High Yield & Leveraged Loan Outlook, 12/16, JP Morgan, JPM High Yield Market Monitor, 1/3/17. Percentage of new issuance calculated on a par value basis. Credit rating agencies, such as Moody’s, Standard & Poor’s, and Fitch Ratings, have letter designations (such as AAA, B, CC) which represent the quality of a bond. Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated. Standard & Poor’s and Fitch assign bond credit ratings of AAA, AA, A, BBB, BB, B, CCC, CC, C, and D. Past performance is no guarantee of future results, which will vary.
So then, what is the opportunity for return? Coupon. And a high-yield coupon, when compared with other alternatives, is still compelling. Also, if you think rates will continue to rise, that means that the economy is doing well, and that’s a positive for the balance sheets of high-yield issuers.
1. JP Morgan Default Monitor, 8/1/17. Defaults based on par amounts.
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.
Past performance is no guarantee of future results, which will vary. It is not possible to invest directly in an index.
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 U.S. High Yield Master Index tracks the performance of U.S. dollar-denominated below investment-grade corporate debt publicly issued in the U.S. domestic market.
Leveraged Buyout (LBO) is the acquisition of another company, using a significant amount of borrowed money (bonds or loans) to meet the cost of the acquisition.
Leverage ratios measure how leveraged a company is, and a company’s degree of leverage (that is, its debt load) is often a measure of risk. When the debt ratio is high, for example, the company has a lot of debt relative to its assets.
The Russell 1000® Index measures the performance of the 1,000 largest companies in the Russell 3000® Index, which represents approximately 92% of the total market capitalization of the Russell 3000 Index.
MainStay Investments® is a registered service mark and name under which New York Life Investment Management LLC does business. MainStay Investments, an indirect subsidiary of New York Life Insurance Company, New York, NY 10010, provides investment advisory products and services.
NYLIFE Distributors LLC is located at 30 Hudson Street, Jersey City, NJ 07302. ALPS Distributors, Inc. is not affiliated with NYLIFE Distributors LLC. NYLIFE Distributors LLC is a Member FINRA/SIPC.