Balancing Risk and Reward in the High-Yield Market
With a new year at hand, it’s a good time to reassess the high-yield market. We recently sat down with the MacKay Shields High Yield Team to discuss current high-yield opportunities and risks.
It is obvious, but important, to recognize that fixed-income markets have benefited from over a three-decade bull market in interest rates. Unprecedented intervention by global central banks has played a large part in creating negative real interest rates. As we know, the level of global interest rates is near its lowest historical recorded levels. Even a moderate spike in interest rates poses a significant risk to all financial markets, including the U.S. high-yield market.
Historically Lower Interest-Rate Sensitivity
If interest rates were to rise, U.S. high-yield bonds should be less vulnerable than other fixed-income markets, due to their shorter duration and the positive correlation between rising interest rates and economic growth. Historically, the high-yield market has been resilient during rising interest-rate environments. Figure 1 below highlights the six times that the 10-year U.S. Treasury rose more than 100 basis points (bps) over a period longer than one year. In the most recent five times, high yield returned greater than 5% during each period. Only in the period beginning in late 1993, did high yield generate a negative return.
Figure 1: High Yield Has Historically Performed Well in a Rising Rate Environment
High-Yield Performance When the 10-Year U.S. Treasury Rate Increased by 100 bps
|U.S. High Yield Total Return||(0.5%)||5.7%||8.9%||48.4%||8.5%||8.8%|
Source: High-yield performance using BofA ML U.S. High Yield Index. Performance for periods greater than a year have been annualized. Period A: 10/31/93 – 11/30/94; Period B: 10/31/98 – 1/31/00. Period C: 6/30/03-5/31/06; Period D: 12/31/08 – 4/30/10; Period E: 7/31/12 – 9/30/13; Period F: 7/31/16 – 12/31/17. It is not possible to invest directly into an index. Past performance is not indicative of future results.
We note, however, that the high-yield market today is more sensitive to interest rates than it has been historically. As the overall credit quality of the high-yield market has improved, lower coupon bonds have grown as a percentage of the high-yield market. Over the past three years, the percentage of bonds with a coupon of 5.5% or less in the Index has increased from 17% to 29%.
High-Yield Credit Fundamentals Remain Positive
In terms of credit risk, we remain constructive on high-yield fundamentals. The credit quality of the U.S. high-yield market continues to be better than it has been historically. The BofA Merrill Lynch U.S. High Yield Index is now comprised of 46% BBs (on a par value basis), up from 36% at the end of 2008. The largest high-yield issuers are generally publicly traded companies. Indeed, approximately 12% of the BofA Merrill Lynch U.S. High Yield Index has been issued by companies in the S&P 500 Index.
Overall, the credit profiles of high-yield companies have remained stable, as evidenced by Figure 2 below, which sets forth the leverage of high-yield issuers over time.
Figure 2: High-Yield Issuer Leverage Levels Have Remained Fairly Consistent
Source: JP Morgan, as of 12/31/17.
Importantly, signs of excessive investor exuberance that have been seen in equities are not evident in high yield. With the volatility of 2015-16 a recent memory and reasonably rich spreads, the high-yield market has not experienced the leverage and heavy allocations often seen near cyclical peaks.
Against the backdrop of a growing U.S. economy, it is likely that the default rate for the high-yield market will remain below its historical average. Recent tax legislation should also benefit high-yield issuers, as a permanently lower corporate tax rate and immediate expensing of CapEx will aid free cash flow available for debt repayment. Most importantly, the potential increase in the after-tax cost of debt, due to interest expense limitations, provides an incentive for companies to only incur moderate amounts of debt.
Tight High-Yield Spreads Leave Less of a Cushion
High-yield spreads are near the tight end of historical ranges, but are not at extreme levels, considering better credit quality and a positive economic trend. As of 1/31/17, the BofA Merrill Lynch U.S. High Yield Index’s spread was 369 bps, tighter than the 20-year median of 521 bps. Spread levels, of course, can remain low for long periods. For example, spreads averaged 371 bps for the three-year period from 2004 through 2006. Historically rich spreads make sense; they are consistent with stock market indexes hitting regular new highs and the low volatility experienced across financial markets (including interest rates) today.
Overall, we continue to believe the U.S. high-yield market represents a reasonable, low-duration, fixed-income investment option. In today’s environment, stable, unleveraged income is difficult to obtain. However, abnormally low interest rates and historically rich spreads mean that the amount of cushion to absorb shocks (e.g., adverse credit events or interest-rate hikes) is not as substantial as it has been.
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.
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.
BofA Merrill Lynch U.S. High Yield Index – The index tracks the performance of below-investment-grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.
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.
Capital expenditures (CapEx) are funds used by a company to acquire or upgrade physical assets such as property, industrial buildings, or equipment. It is often used to undertake new projects or investments by the firm.
A credit spread is the difference in yield between two bonds of similar maturity, but different credit quality.
Free cash flow (FCF) yield is an overall return evaluation ratio of a stock, which standardizes the free cash flow per share a company is expected to earn against its market price per share. The ratio is calculated by taking the free cash flow per share divided by the share price.
S&P 500 Index is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion.
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