While many segments of the bond market have struggled in the face of plummeting interest rates, one area that has been increasingly attractive to income investors has been high yield. Unlike 2011 which saw long-term treasuries outperform US corporate high yield by a six-to-one margin (according to figures from Barclays Capital), the global high-yield market began the current year in top form, with portions of the sector topping 8% as of late May.
With corporations de-leveraging and balance sheets improving, high-yield fundamentals appear to be sound (and include a record low default rate), while new issuance has been largely limited to extending maturities and boosting liquidity.
Though price action is typically impacted by global-macro volatility concerns (particularly with respect to the situation in Europe), the sector’s aggregate yield has advanced approximately 100 basis points since the start of the year, which could help attract even more investors going forward. Accordingly, many observers remain unusually bullish toward high yield corporate bonds and their attractive risk-adjusted returns, and believe these investments will be aided by the central-banking pro-growth monetary policy of the US and EU.
Credit fundamentals remain reasonably healthy across most sectors, particularly within the US and developed areas, affirms David Leduc, chief investment officer of Standish Mellon Asset Management’s active fixed income division. “We have been a bit lighter on energy given the recent fluctuation in oil prices and other concerns,” says Leduc, “however on balance we’ve liked what we’ve seen.” Earnings have been strong, says Leduc, and the vast majority of companies have been able to secure financing at historically favorable terms, giving them greater flexibility.
As one would expect, the top end of the yield curve has been shaped for the most part by lower-rated issues, with some CCC-rated products approaching the 10% mark. Emerging-markets high yield has garnered significant interest, while European high yield continues to lead the pack on a global basis. “Euro spreads have been consistently higher,” says Leduc, “which helped the sector outperform during the first part of the year.” Navigating the financial space has been tricky, though, says Leduc. “There have been a lot of fallen angels particularly around European bank sub-debt, and we’ve tended to steer clear as a result.” Attractive opportunities in the US include various issues in the lease-finance sector; communications has had its share of good performers, and Standish Mellon has also benefited from positions in the US auto sector, particularly in light of recent upgrades.
Even those with a reduced appetite for risk have seen returns in the vicinity of 4% or higher from certain higher-rated (BB and B) issues. “Some of the smaller names in Latin America and Asia have paid upwards of 60 basis points (bps) higher than their US counterparts, simply because they may have better credit metrics including lower leverage and higher interest coverage,” says Leduc. “While it might not sound like that big a deal, when you have 10-year treasury bonds yielding less than two percent, it does mean something.”
The perception that the Fed will keep rates at low, combined with the positive direction of corporate balance sheets, has helped boost comfort levels, says Brian Kinney, managing director at State Street Global Advisors (SSgA). As such, investors are increasingly viewing high yield as a plausible mechanism with which to diversify away from lower-paying government bonds, or to use high yield in part as a hedge against inflation.
“Not only are clients moving into these types of asset classes in greater numbers, they are doing so in a way that they feel will provide them with the most liquidity,” says Kinney. Given the illiquidity licking that many an investor suffered pre-crisis, it’s not that surprising that the vehicle of choice for high-yield entry has often been exchange-traded funds. During the first quarter alone, roughly 25% to 30% of total high-yield inflows arrived via ETFs, with the majority directed toward State Street’s SPDR Barclays Capital High Yield Bond ETF as well as iShares’ iBoxx $ High Yield Corporate Bond ETF (the two funds currently account for an estimated $25bn combined).
Because high-yield ETFs tend to invest in a smaller number of larger, more liquid issuers, there is a bit of a trade-off between liquidity and broad exposure when compared to institutional fixed-income high-yield benchmarks. It’s a sacrifice that many clients have been willing to make, says Kinney. “If you look at the performance of high-yield managers versus the index, on balance the returns haven’t been all that different,” says Kinney. “Particularly when you consider the importance of liquidity to investors nowadays, you can see why ETFs have become a legitimate choice for clients in support of high yield.”
Despite the upward trend, managers have been loath to keep the pedal to the medal, given the perpetual ebbs and flows of economic developments both at home and abroad. In contrast to the buoyant first quarter that saw major fund flows into high yield, the economic realities of Q2 subsequently sucked some of the joy back out of the markets; though still north of 5% on an aggregate basis (as of June 30th), corporate high-yield indices have since retraced much of the gains tacked on earlier in the year.
“There could still be a fair amount of volatility into the foreseeable future,” says Leduc, “which is important to keep in mind, particularly when using high yield in accounts that may not be totally dedicated to that asset class. Things have clearly gotten a bit softer in the US during the second quarter, which isn’t all that surprising given the higher-than-average performance we saw during the previous quarter, nevertheless it does bear watching. But there are other things to look out for as well—China’s growth has been slower than the markets had previously expected, and of course Europe continues to struggle with the sovereign-debt problem. So global-growth concerns do remain at the forefront, and even though it’s not our view, should there be a more meaningful pullback in the US economy, that would certainly not be constructive for high yield. While we’re not necessarily building those expectations into our high-yield strategy, it is something we need to be cognisant of as we move forward.”
Still, experts such as Kinney prefer to look at the bigger picture. “The fundamentals story, which is about corporations’ balance sheets, cash on hand, and access to the capital markets is still quite positive,” says Kinney. “If you forget about the spreads and just focus on the absolute yields, you see that corporations are in better shape than they’ve been in years. You also have a very strong technical story in the sense that there is a lot of liquidity in the system right now—and the indirect result of the Fed putting all of this money into the system is that absolute yields in other asset classes have been driven very low. So as a relative-value proposition high yield looks very attractive, particularly in a market that is awash in liquidity and other yields are at their historical lows.”
Despite some suggestions that government regulation has lead to greater inefficiency and the potential for market dislocations, the improved transparency has allowed investors to breathe a bit easier whilst on the high-yield hunt.
“Say what you want about regulation—the fact of the matter is that investors have been able to look at corporate balance sheets and have a much better understanding of what’s actually behind them,” says Kinney. “The ability to analyse and subsequently invest in corporations is probably better than it’s ever been, and that is certainly one of the more positive aspects of the increased disclosure around what corporations are doing with their money. And the high-yield market has really been one of the key beneficiaries of that trend.”