Four Pillars of a Strong High-Yield Foundation
Though the overall U.S. fixed-income market has been largely flat over the last 12 months, the high-yield bond market has been a solid performer. While the factors driving these strong results are still in place, given the magnitude of spread tightening, a more selective approach may be warranted going forward. We interviewed Michael Snyder, Managing Director and Senior Portfolio Manager for the MacKay Shields High Yield Team to get his thoughts.
Working with a Solid Foundation
Can high-yield spreads remain range-bound or continue to grind tighter? While there are certain risks, including Federal Reserve missteps and geopolitical issues, we believe the high-yield market remains on solid footing.
1. Strong Overall Fundamentals
Fundamentals in the high-yield market are solid overall. Corporate profits have been on the rise, many issuers have shored up their balance sheets, and cash-flow levels in most sectors have improved. In addition, high-yield issuers have seen stable-to-improved leverage levels. Against this backdrop, the high-yield upgrade/downgrade ratio has been positive for three consecutive quarters.
LTM Upgrade/Downgrade Ratio (Number of Issuers)
Sources: JP Morgan, Moody’s Investors Service, S&P, as of 10/31/17. LTM = Last Twelve Months.
2. Positive Credit Metrics
A large portion of the new issue market continues to be refinancing—almost 62% year-to-date—versus roughly 58% in 2016. This is a positive for the high-yield market, as it lowers the average finance cost to the company and extends maturities, as shown below. In addition, leveraged buyouts (LBOs) as a percent of the new issuance remain historically low. Looking back, LBO-related issuance pre-crisis 2008 was approximately 35% of the market. That fell to almost nothing in 2009, and it has averaged between 3% and 4% since then.
High-Yield Bond Maturity Schedule
Source: JP Morgan. High-yield bonds are represented by the JP Morgan U.S. High Yield Index.
3. Low Defaults
As a byproduct of solid fundamentals, the high-yield default rate is currently around 1%, significantly below the 4.89% default rate from 18 months ago. In addition, the average recovery rate is 49%, well above the 25-year average.1
4. Positive Technicals
High-yield technicals are also positive. Demand remains robust overall, as investors look for yield in the low-rate environment. In terms of supply, the percent of new issuance in the market has skewed to BB- and single-B. In contrast, in 2007, there was a much higher rate of CCC new issues and LBO financing issuance.
The Result: Tighter Spreads
Given the high-yield market’s extended rally, spreads are less compelling, currently between 375 and 400 basis points (bps), depending on the index. In contrast, the 20-year median is in the low 500s. Yet, today’s spreads are not at the extreme level we saw prior to the financial crisis, which was in the mid-to-high 200s. In our view, today’s spreads are supported by fundamentals, low default rates, and strong credit metrics. Under the right credit conditions, spreads can stay low for an extended period of time.
The Power of the Coupon
A key—and sometimes overlooked benefit of investing in high-yield bonds—is the power of the coupon. For example, if your high-yield portfolio is yielding 6% and nothing else happens all year, you still get the 6% return. In contrast, if you own an equity portfolio and nothing happens all year, there’s no return. Even if rates back up and eat away at part of a high-yield portfolio’s return, this could be partially cushioned by the coupon.
The Sweet Spot in High Yield?
Based on the spreads for various portions of the high-yield market, we believe the risk/reward profile has shifted and now favors relatively higher-quality securities. That’s because the CCC spread cushion has compressed. As such, we don’t feel investors are being adequately compensated for the incremental credit risk. Rather, we think the BB- and single B-rated buckets have better risk/reward characteristics. That’s not to say there aren’t opportunities in the lower-rated space, but we feel issue selection will be critical to success in the current environment.
1. JP Morgan, 11/1/17.
Opinions expressed are current opinions as of the date appearing in this material only. The information and opinions contained herein are for general information use only. MainStay Investments does not guarantee their accuracy or completeness, nor does MainStay Investments assume any liability for any loss that may result from the reliance by any person upon any such information or opinions. Such information and opinions are subject to change without notice, and are not intended as an offer or solicitation with respect to the purchase or sales of any security or as personalized investment advice. There can be no guarantee that any projection, forecast, or opinion in these materials will be realized. Past performance is no guarantee of future results.
This material is provided for educational purposes only and should not be construed as investment advice or an offer to sell or the solicitation of offers to buy any security. Opinions expressed herein are current opinions as of the date appearing in this material only.About RiskAll investments are subject to market risk, including possible loss of principal. There is no assurance that the investment objectives mentioned will be met. Diversification cannot assure a profit or protect against loss in a declining market.
Index performance is shown for illustrative purposes only and does not predict or depict the performance of the Funds. Indices are unmanaged, include the reinvestment of dividends, and cannot be purchased directly by investors. Past performance does not guarantee future results.
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.
Bonds are subject to interest-rate risk and can lose principal value when interest rates rise. Bonds are also subject to credit risk, which is the possibility that the bond issuer may fail to pay interest and principal in a timely manner. 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.
Credit ratings 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.
High-yield bonds are represented by the JP Morgan U.S. High Yield Index.
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.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
JP Morgan U.S. High Yield Index is designed to mirror the investable universe of the U.S. high-yield corporate debt market, including issues of U.S.- and Canadian-domiciled issuers.
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.
Technical indicators (technicals) are used most extensively by active traders in the market, as they are designed primarily for analyzing short-term price movements. The most effective uses of technicals for a long-term investor are to help identify good entry and exit points for the stock by analyzing the long-term trend.
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