High Yield—Reasons for (Cautious) Optimism
The high-yield bond market has not escaped the market’s recent volatility, although it has been fairly resilient compared to some other asset classes. For example, during the second week of February, the S&P 500 Index declined more than 7%. High yield, on the other hand, fell a more modest 1.8%, as measured by the BofA Merrill Lynch U.S. High Yield Index. While no one knows where the markets are headed next, we spoke to MacKay Shields’ High Yield Team and have several reasons to remain cautiously optimistic for the high-yield asset class.
An Extended Credit Cycle
While this credit cycle has been longer than most, fundamentals remain solid. We don’t see aggressive new issuance in the form of leveraged buyouts (LBOs), which often accompany credit cycle turns. Additionally, a cycle turn typically coincides with an economic downturn, which does not seem to be in the cards for the foreseeable future. As shown in the chart below, more speculative new issuance has been modest, with a larger portion of the high-yield market consisting of relatively higher-quality BB-rated bonds. Against this backdrop, it’s not surprising that high-yield defaults have been modest.
Aggressive Issuance Not Evident
|% of New Issuance||A. 1997 – 2000||B. 2004 – 2008||C. 2013 – Present|
|Leveraged Buyouts (LBO)||0.1||22.6||3.3|
Sources: JP Morgan, BofA Merrill Lynch, as of December 31, 2017. Default rate includes distressed exchanges. * Non-Cash Coupon Issuance includes Zero Coupon bonds, Pay-in-Kind (PIK) bonds, or PIK Toggle bonds. 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 Moody’s assigns bond credit ratings of Aaa, Aa, A, Baa, Ba, B, Caa, Ca, and C, with WR and NR as withdrawn and not rated.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.
A Buffer in a Rising Rate Environment
Based on Federal Reserve Chair Jerome Powell’s February 27th congressional testimony, the U.S. central bank remains on track to continue its campaign of raising interest rates in 2018. This typically sets off alarm bells for certain portions of the fixed-income market—but not typically for high-yield bonds. This is illustrated in the chart below. The shaded areas show periods when the 10-year Treasury yield rose more than one percentage point. During those environments, high yield performed relatively well and only declined once—a modest 0.5%—in the early 1990s. To some extent, that’s because, historically, rates generally moved higher when the economy was doing well, which is a positive backdrop for high yield. In addition, high yield is generally a low duration asset class with attractive coupons. Therefore, when interest rates were rising, it was possible to reinvest maturing securities at higher rates.
U.S. High Yield Has Performed Well in Rising Rate Environments
Performance in Rising Rate Environments
|U.S. High-Yield Total Return||(0.5%)||5.7%||9.9%||48.4%||8.5%||8.8%|
Source: High-yield performance represented by the BofA ML US High Yield Index. Performance for periods greater than a year has 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, and 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.
The Positive Aspects of U.S. Tax Reform
In our view, the recently passed U.S. tax reform bill is an overall positive for the credit market. First, the corporate income tax rate fell from 35% to 21%. This should help to improve after-tax cash flows. As such, companies will have more cash to pay down debt and invest in their businesses. The treatment of capital spending is also beneficial. That’s because those expenditures are now 100% written off in the year they’re incurred. Not only should this reduce corporate tax bills, it should improve the availability of free cash flow. One negative, however, is that the deductibility of net interest expense is limited to 30% of EBITDA. This is a bigger issue for CCC-rated and stressed issuers with low interest coverage ratios, whereas higher-quality and BB-rated issuers should be less impacted. All told, over the long run, the credit quality of the high-yield market should be enhanced, as companies have less incentive to incur more leverage as the after-tax cost of debt increases.
A Potential Red Flag
From a historical perspective, high-yield spreads are on the rich side. To some extent, this makes sense, given the outlook for low defaults. And, high yield isn’t alone in this regard, as valuations from other risk assets, such as equities, emerging market debt, and investment-grade bonds, are trading toward the rich end of the spectrum. By their very nature, high-yield bonds offer a higher coupon, but the ability for them to generate meaningful capital appreciation at current levels is rather limited. Still, we see demand remaining solid overall, given the lack of yield available to investors from around the globe.
U.S. High-Yield Spreads Are Less Compelling
Source: ICE BofA Merrill Lynch U.S. High Yield Index, as of February 21, 2018. The spread to worst measures the difference from the worst performing security to the best, and can be seen as a measure of dispersion of returns within a given market or between markets. It is not possible to invest directly into an index. Past performance is not indicative of future results.
After a prolonged period of muted market volatility, the uptick we’ve recently experienced could continue. That by itself, however, doesn’t necessarily equate to poor performance from the high-yield market. Fundamentals overall are on solid footing, high yield has traditionally performed well during economic expansions/rising rate environments, and their coupon could provide a buffer during risk-off periods. That being said, given current valuations, we continue to believe thorough credit analysis and security selection will be of the utmost importance.
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.
Neither New York Life Investment Management LLC, nor its affiliates or representatives provide tax, legal or accounting advice. Please contact your own professionals.
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.
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 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.
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.
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.
Payment-in-kind (PIK) is the use of a good or service as payment instead of cash. Payment in kind also refers to a financial instrument that pays interest or dividends to investors of bonds, notes or preferred stock with additional securities or equity instead of cash.
PIK toggles pay interest in cash at one rate or, at the company’s option, pay interest in additional PIK toggle notes. The interest paid in additional notes is set at a higher rate than the cash interest rate.
S&P 500 Index is an index of 505 stocks issued by 500 large companies with market capitalizations of at least $6.1 billion.
Zero coupon bond is a bond that is issued at a deep discount to its face value but pays no interest.
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MacKay Shields LLC is an affiliate of New York Life Investment Management LLC. New York Life Investment Management LLC serves as the investment manager of the MainStay Funds. 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. Securities distributed by NYLIFE Distributors LLC, 30 Hudson Street, Jersey City, New Jersey 07302. NYLIFE Distributors LLC is a Member FINRA/SIPC.