High-yield corporate bonds: A mispriced opportunity under most scenarios
Market insights: February 23, 2016 • iA Clarington Investments Active Insights
Dan Bastasic MBA, CFA
Senior Vice-President and Portfolio Manager
Amid an environment of significant volatility and widening spreads, the high implied default rate being priced in suggests that the high-yield market is anticipating a recession.
While a recession would represent a major risk to the highyield market, there is no clear evidence to indicate that a recession is imminent, as global liquidity and the health of the U.S. consumer remain sound.
Considering the current total return profile of the asset class, the healthy yields provided by high-yield corporate bonds can enhance returns if spreads tighten or help mitigate losses if spreads widen.
Attractive opportunities in the high-yield market exist for active managers to uncover and secure on behalf of investors.
1. The high yield market is pricing in a recession.
It was a tale of two markets for high yield in 2015. The highyield market returned low single digits in the first half of the year, slightly outperforming investment-grade securities. However, the market was then shaken by fears of contagion, widespread negative sentiment and persistent volatility – all of which have continued so far in 2016.
The primary catalysts for volatility in the second half of 2015 were economic weakness in China, the potential for the U.S. Federal Reserve Board (Fed) to raise interest rates, the sharp decline in oil prices and the freezing of withdrawals for certain funds that focus on distressed debt, as redemption requests ran so high that outflows could have caused a major disruption to the funds.
Combined, these events have caused spreads in the high-yield market to widen by approximately 200 basis points as prices have fallen dramatically. This widening of spreads has called into question the health of the high-yield market, as spreads are often used to gauge the overall condition of the credit market. Higher spreads indicate that the market perceives a greater risk of default, and therefore investors are demanding a higher risk premium to compensate. In turn, the high implied default rate (Figure 1) suggests that the high-yield market has priced in a recession.
2. While recessions are a risk to the high-yield market, a recession does not appear imminent.
Recessions, specifically in the U.S., are a major threat to the high-yield market because, on a historical basis, they have hurt investors’ portfolios by increasing default rates among the most asset-poor companies. Without a recessionary environment, businesses can typically sustain sales and reduce costs while the market adjusts for the risk/reward trade-off between investing and abstaining.
While the markets are approximately 80% of the way to spread levels that were evident in the last moderate recession of the early 2000s, a full recession does not appear forthcoming in 2016. Global liquidity and U.S. consumer strength are two fundamental indicators of whether a recession can be expected. Let’s consider each to determine the probability of an impending recession.
Global liquidity generally refers to the availability of funds to purchase goods or services, or obtain financing. Adequate liquidity is essential for a vibrant global economy, while reasonable liquidity levels minimize the risk of recession. Global liquidity is critical to high-yield returns, as it has an impact on company fundamentals. When consumers have ready access to funds to purchase goods and services, it drives the revenue and earnings for high-yield issuers, helping them pay debtholders.
In the short term, the ability of firms to generate cash flow for repaying obligations is affected by decreasing gross domestic product (GDP) growth, or by recession. A key measure of liquidity is money supply. “M2” is a measure of money supply that includes cash, chequing deposits and balances in money market funds – liquid assets that can be deployed quickly to purchase goods or services. M2 has been volatile since 2008, but after bottoming in mid-2013, has improved on a year-over-year basis (Figure 2). With global liquidity – as measured by M2 – rising, it limits the near-term chance of recession.
Figure 2: Global real M2 year-to-year change
Source: Haver Analytics
So, what about the U.S. consumer? Consumer spending accounts for nearly 70% of the country’s GDP and is the engine that keeps the economy moving. U.S. consumers are so important to the U.S. economy that they can actually offset global weakness (as measured by a drop in net exports). All told, the fundamentals of the U.S. consumer look fairly healthy at this time. The unemployment rate has dropped to 5% since peaking at 10% in 2009 (Figure 3). In 2015, full-time employment growth was more than 200,000 a month on average, while real weekly earnings rose (Figure 4). These indicators suggest the U.S. consumer is doing well and the U.S. economy is currently not heading into a recession.
Figure 3: Average monthly employment growth
Source: U.S. Labor Department | WSJ.com.
Figure 4: Employment change since June 2009 (3-month moving average)
Source: U.S. Labor Department | WSJ.com.
As global liquidity and the U.S. consumer appear healthy, the likelihood of an impending recession remains low, suggesting no expected spike in default rates from the relatively low levels in the current environment. It seems incongruous, then, for the implied default rate currently being priced in the market to climb to an outsized 7.8%, especially considering that the latest default rate sits at a manageable level (Figure 5), and credit rating agencies such as Moody’s Investors Service and Fitch Ratings are forecasting it to remain under 5% for 2016.
Figure 5: High yield spread and default rate
Source: Bloomberg and BofAML (January 31, 2016). High-yield spread based on OAS.
3. Two-year scenarios for high yield.
Although volatility and a widening of spreads in the high-yield market have caused concern, investors can take some comfort in the relative prospects for high yield that are evident in an examination of potential two-year scenarios for the asset class (Figure 6). Currently, the high-yield index is yielding 9.9%. Over the next two years, if high-yield spreads were to remain unchanged, the gross yield would be approximately 19.8%. Even if a 5% default rate is factored in, it means an investor has the potential to achieve (gross of fees) a two-year yield of 14.8%, or an annualized 7.1% return.
A two-year yield of 14.8% is an attractive prospect in any market, but what about the impact on price, and total return, if spreads were to tighten or to widen? In a scenario where the risk of defaults lessens with improving economic fundamentals, high-yield spreads will tighten. This spread tightening would have a positive impact on price and total return. On the other hand, spreads will widen if the risk for defaults increases due to a worsening economic outlook or recessionary pressure. This would cause prices to fall and have a negative impact on total return. In Figure 6, we outline a range of potential spread scenarios over a two-year horizon and their impact on total return.
It is evident that under this plausible range of scenarios for the asset class, a high-yield investor could experience an annualized return of 13.1% in the most optimistic scenario, where spreads tighten 300 basis points (bps). Conversely, in the least optimistic scenario, where spreads widen a further 300 bps from current levels, investors could still realize a 0.8% annualized return. Both extremes highlight the positive impact that the relatively healthy current yield of 9.9% now offers to enhance total return potential and the importance of staying invested so that you can fully realize the income component of return. Most notably, for those fearing any additional contagion in the asset class, the high yield currently offered can act as a buffer to help offset the impact of any potential future price declines.
The case for active management.
Overall, key indicators are pointing to a relatively attractive environment for high yield in 2016. Even if the market has assessed the situation correctly regarding default rates, it would appear that most of the damage has already taken place, based on historical comparisons. That’s not to preclude the possibility of more downside in a recessionary environment should that scenario arise, but such a drawdown and the resultant wider spreads and higher yields would set up an even more favourable return profile over the subsequent 12- to 18- month period.
Managers equipped to assess the economic fundamentals behind the high-yield market and to gauge their impact on this asset class can readily determine potential valuation anomalies. These managers can, in turn, deploy capital toward the names that should provide the best value on a relative basis on behalf of investors. High yield is a market where you must be active, and that is even more imperative in the current volatile environment. In 2016, the nimble active manager should be well positioned to capitalize on current valuations, as well as to seize any additional relative opportunities that arise.
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Dealer use only. Unless otherwise indicated, all data is as at February 23, 2016.
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