Fixed Income Boutique
“Hi Brian, We noodled on this over the weekend and circled back to spitball some scenarios. So here’s the rub: we’d like you to do the heavy lifting on this one. You know, before anything falls through the cracks. The ball’s in your court to run the numbs and get all our ducks in a row. Make sure you let it marinate before jumping to any conclusions. However, because we’re only in the fifth inning we need to make sure we run through the tape.”
If you watch financial television, you will have heard phrases like these coming from the mouths of market pundits. Many times, if you listen carefully and boil down what they are saying to its essence, you are left with very little. At Vontobel, we don’t work this way, and rely on our research to identify the cold, hard facts, take an independent view and then share them with our investors in plain English your parents could understand. So, after one particularly irritating broadcast this week, I decided I would translate some of the phrases I’d heard into some good, honest market commentary about the opportunities on offer in the US high-yield market.
The US high-yield market is on a solid footing with low default rates and credit spreads hovering around 14-year tights. This is nothing short of amazing, given where we were just 15 months ago. The key concern now is, how long this can continue and should investors continue to reach for yield given the well-documented risks of inflation, Covid variants, and too much debt in general for both corporations and sovereigns. We are comfortable that the good times in high yield (and credit in general) can continue for the foreseeable future. Our view is centered on the three pillars of fundamentals, technical, and valuation. The valuation aspect is the most difficult right now, given how far spreads have compressed in anticipation of a full economic recovery. To get comfortable at current valuations requires a deep understanding of where we are in the cycle and why it is quite possible that this time truly is different and we can grind tighter and/or enjoy the carry.
Fundamentals for the US high-yield market are strong. Hence, the weight-lifting reference popularized by a viral Youtube video. In terms of the market, we must acknowledge that, yes, leverage levels are extremely high but this should be temporary given the economic rebound that virtually all industry sectors are currently enjoying. Investors are able to “look through” this period of high leverage because companies are seeing a rebound in sales and have significant liquidity to fund operations and working capital as these sales orders improve. Management teams took aggressive actions to minimize the impact of the pandemic on their businesses. As such, companies have been able to “weather the storm” quite well and enacted further cost-saving measures, some of which should be permanent. Ratings upgrades support the theme of improving fundamentals. Year to date, we have seen upgrades for 359 billion vs. 160 billion US dollars for downgrades.1 Fundamentals, as illustrated by credit metrics, are improving considerably in 2021 as actual results start to flow through and the bad quarters from last year roll off. Four key question to keep in mind are:
We think there is room for further improvement and with a growing economy, it should continue. This is further supported by corporate financial discipline evidenced by modest capital expenditure this year, which should extend into 2022. There is a keen focus to maximize cash flow and debt reduction (e.g. in the energy sector).
Technicals are the second leg of the credit-investing tool and while not currently as much of a slam-dunk as the strong fundamentals, it is currently healthy overall and further supported by the more macro technicals associated with the US Federal Reserve’s accommodative monetary policy. It helps to have a healthy new issue market and this is clearly the case in 2021. New issuance for US high yield in the first half of 2021 was approximately 278 billion US dollars, or 31 percent higher than over the same period last year, according to Bank of America Merrill Lynch.2 While more supply could result in lower prices, this is not the case as supply has been more than offset with strong demand from investors across the globe. High demand typically lowers the required coupon needed to price new deals, which further underpins secondary pricing.
Furthermore, a healthy primary market allows issuers to refinance and extend their maturity profile, which strengthens fundamentals. The hunt for yield attracts all types of investors, from insurance companies to crossover funds. This can be an issue if and when these investors, or “tourists”, change their strategies and reduce high-yield exposure. Separately, fund flows in US high yield have been a bit choppy so far this year, as investors grapple with risks such as duration (less of an issue in high yield than investment grade), or default risk (are we picking up pennies in front of the steamroller?). The fund flow effect is currently more neutral for the US high yield given small retail outflows (approximately 1.4 billion US dollars year-to-date through June) and larger institutional fund outflows (around 10.3 billion year-to-date).3 Overall, we think the technicals are fairly balanced with the potential that flows into high yield could turn more positive if interest rates do not rise significantly and spread volatility remains low as investors seek higher yielding alternatives.
Valuation is the third leg of the credit-investing tool and is often characterized as rich, cheap, or fair value, depending on expectations going forward although many investors are guilty of looking in the rearview mirror to justify their views. High-yield spreads, or the return in excess of the corresponding treasury rate, are currently hovering at 14-year tights. The obvious call is to just say the market is rich, or expensive, and that prices need to come down in order to increase yields and spreads to a more appropriate level for the risk. We would argue that spreads, while tight, are not necessarily rich and could grind even tighter over time.
One of the best arguments that spreads are not too low is centered on the outlook for default rates. High-yield default rates have declined significantly as large default volumes from last June have rolled off the loan-to-maturity (LTM) default rate calculations. Even recently, major financial institutions have further reduced their default-rate forecasts to reflect this healthier credit environment. According to JPMorgan, the default rate for US high-yield issuers (including distressed) at the end of June 2021 was 1.87 percent. With improving fundamentals, this is now expected to decline to 0.65 percent for 2021 (vs. previous forecasts of 2.0 percent). Other analyses support further spread tightening by adjusting historical high-yield spreads for today’s duration and ratings breakdown. This would suggest that the all-time tights were well below current levels at around 200 basis points, reached in 1997, 2005 and 2007. Overall, we believe credit spreads have some room for further spread tightening although the compression in June did eliminate some of this cheapness.
We leave you with the final thought that the remainder of the year should be supportive of earning carry in the US high-yield market. Fundamentals are improving and this should continue into next year. Technicals remain supportive (or at least not detrimental). Valuation is not cheap but has some room to grind tighter, supported by low default rates and higher overall quality mix as compared to previous cycles. As always, we value credit selection above all else. In other words, “Whether you lean into it, or pull back on the throttle, make sure you run it up the flagpole so that we’re all on the same page!”
1. JP Morgan, High Yield Bond and Leverage Loan Monitor, 1 July 2021
2. Bank of America Merrill Lynch, Daily High Yield Strategy email, 2 July 2021
3. Bank of America Merrill Lynch, Daily High Yield Strategy email, 2 July 2021