With high yield spreads approaching post-crisis lows, we examine the drivers behind recent strength in the market and offer our views on how to position for success going forward.
Not the time to reach for yield
While most financial markets across the globe were not immune from bouts of summer volatility, the US high yield (HY) market enjoyed a remarkably resilient past couple of months. Yield spreads and yields to worst barely changed between early June and mid-September. Aided by a stabilisation in Treasuries, duration fears abated and this resulted in a benign environment for fund flows. Combined with a continuation of lacklustre supply, the technical tailwind for the asset class remained strong, bringing its total return to approximately 2% in the year to date.
While a 2% return nearly three quarters of the way through the year is not particularly exciting by the historical standards of the HY asset class, it does stand out when compared to other asset classes around the globe so far this year.
Triple C-rated bonds have outperformed significantly in 2018, generating a total return of approximately 5% over the year to date, a return that has been largely driven by the lowest quality CCCs. This compares favourably to total returns in the single B space of 2.5% and BB returns that are essentially flat. It also illustrates a prevailing trend this year – the “hunt for yield”. Investors are electing to buy higher spread names, choosing credit risk over duration risk, and in turn propelling the lower quality portion of the market upward. 2018 still stands out as an anomaly in the historical context of the HY asset class. If current trends hold, this would be the first year ever where CCC-rated securities have outperformed the overall HY market when the overall market generates a sub-coupon total return. In fact, it’s rare to see CCC outperformance versus the overall market, regardless of the absolute level of market return, in the back half of the credit cycle.
The question going forward is: when do investors begin to focus their attention once again on credit risk?
The question going forward is: when do investors begin to focus their attention once again on credit risk? Clearly the direction of rates will play a role in portfolio positioning, but it’ll be the movement in credit spreads that will ultimately drive total returns over coming years.
The unusual effects of the various forms of quantitative easing (QE) have played an important role in supporting the HY market over recent years. As QE across the globe has pushed investors down the credit stack in search of yield, HY has benefited from increased demand.
This is not to imply that fundamentals have become irrelevant in today’s market – just less relevant than in the past, given the QE tailwind. With the technical backdrop supportive and total return prospects low across the higher quality portion of the market, investors have sought out total return in the lower quality portion of the market. Hiding out from duration has worked well; the two best performing sectors so far this year in the US are pharmaceuticals and wirelines, the two highest-yielding sectors in the market. Additionally, on the supply side, gross supply is down by more than a fifth in the year to date. This is because a combination of a receptive loan market and decreased merger and acquisition (M&A) activity among HY companies has driven down HY funding needs.
That being said, September marked the return of the supply calendar in HY, largely driven by a recent pickup in M&A activity that resulted in a skew towards lower quality issuers. First-time issuers such as Refinitiv, a loose covenant leveraged buyout of a Thomson Reuters business segment and CarVana, a technology-focused used car dealer with negative earnings before interest, taxation, depreciation and amortisation, are indicative of the quality on the current calendar. Does the return of low-quality supply mark a turning point for the market? Possibly not, but it should not be ignored as a potential harbinger of future volatility in what has been a remarkably tranquil market. Careful attention should be paid to indications of indigestion in the loan market which could have a ripple effect on HY.
On the fundamental side, balance sheets remain in good shape and corporate earnings have generally supported a slowly improving fundamental picture.
(That being said, for the one-off issuers who did miss on earnings, bonds failed to find a floor as investors have been hesitant to ‘catch a falling knife’ in the current market. This is typical late-cycle behaviour where liquidity is fleeting among problem credits.) Defaults are expected to stay low as companies have been diligent in refinancing at low rates and covenant relaxation trends in both the bond and loan market will provide issuers with flexibility should issues arise.
If fundamentals remain supportive and external shocks minimal, the HY market may have a few more years of low/mid-single digit total returns ahead. However, given where we are in the credit cycle, and taking into account the reversal of monetary tailwinds, reaching for yield is not prudent at this point. We prefer to take a more cautious approach, positioning for success over the longer term with a focus on identifying improving credits with defensible cash flows. By remaining diligent and avoiding the temptation of overreaching, HY investors should be able to generate total returns over coming years that are attractive both in absolute and relative terms. As always, credit selection will be the key to success; that means picking the winners and, more importantly, avoiding the losers.