A Most Unusual Cycle – The Shrinking of the High-Yield Market
There are many aspects of this credit and business cycle, which continue to surprise investors and differ from the textbook expectations of an aging bull market. Our experts explore one aspect unique to the high yield market, which can help explain the relentless demand for bonds.
Along with many asset classes, so-called “junk” bonds are experiencing a year of unparalleled tranquility. Indeed, the Bank of America U.S. High Yield Index is trading in the tightest spread range of the past 20 years, with a high-to-low range in spreads of only 71 basis points (bp) year to date, while the range has been 123 bp for the Bank of America European High Yield Index. This compares to an average of 481 bp for the U.S. index over the last 10 years, since the start of the Global Financial Crisis.
While the reasons for the low-volatility environment across asset classes are well rehearsed, we wanted to explore one aspect, which is unique to the high yield market and can help explain a relentless demand for bonds. Quite simply, the U.S. high yield market is beginning to shrink. In doing so it is following in the footsteps of the European high yield market where the par value (notional amount) of bonds outstanding peaked in 2014 and has been notably lower ever since (Exhibit 1).
Exhibit 1: Shrinking High-Yield Markets
Explaining the shrinkage in the market is relatively simple; it is due to a number of forces, which are explored below. Before doing so however, it is worth taking a step back to reflect on the fact that eight years into a bull market, with close to record-low yield levels, corporates appear to lack the exuberant animal spirits that in the past would have encouraged a leveraging up of balance sheets.
It would appear that the scars of the previous crisis continue to run deep. We have spoken in previous articles and videos about the experience of Japan and the lasting impact of a “balance sheet recession” on both corporate and household attitudes to debt. It is also the case that a low- growth and low-inflation backdrop makes it hard for companies to envisage “growing into” a highly indebted capital structure. Europe led the way in this regard but it is fascinating to see similar footprints in the U.S.
Changing Corporate Behavior
Facing an economic environment with stagnant growth, European corporates have remained relatively conservative in their behavior. We have commented in the past on the low levels of European merger and acquisition (M&A) activity in this business cycle relative to previous cycles, and to the U.S.
This is particularly noteworthy given how cheaply European corporates can borrow in public bond markets. The European investment-grade market currently yields 0.75%* and the European high-yield market yields 2.12%. The lure of cheap debt seems to exert little force on the European corporate psyche. This has not been the case in the U.S. where investment-grade companies have taken full advantage of lower bond yields in this cycle in order to return cash to equity investors.
The U.S. high yield market, however, currently seems to have more in common with Europe, driven by a cautious attitude among private equity sponsors. This is very different to the gung ho attitude exhibited during the 2005-2007 private equity boom.
Resurgence of Rising Stars
While the number of credit rating downgrades has exceeded the number of upgrades in the high-yield universe, the volume of debt being upgraded to investment grade has far outweighed that being downgraded to the high yield index.
Typically, it is companies with the bigger capital structures (which make up a larger part of high yield indices) that are engaged in improving their credit profile. Not only does this give them access to cheaper and more plentiful funding (should they need it) in the investment-grade market, if and when this cycle eventually turns, they will also be in a relatively better position to weather the storm.
The result is — across both U.S. and Europe — a smaller high yield market, as more bonds are upgraded to investment grade.
The upgrade of Anglo American alone earlier this year, resulted in the loss of $9.6 billion (par value) of bonds in the U.S. high yield index. Tesco, which makes up 5.7% of the smaller sterling high yield index, has announced it is focusing on a return to investment grade and is buying back debt with that view in mind. In the case of the European high yield market, Barclays estimates €20 billion of debt (par value) will migrate from high yield to investment grade in 2018 with only approximately €5 billion going in the opposite direction.
A Newfound Affinity With Loans
In addition to corporates’ changing business strategies, the high yield bond market has faced cannibalization from its sister asset class — leveraged loans.
Indeed, possibly the biggest trend in the past two to three years for the high yield market has been the resurgence of loan issuance driven by the continued strong demand for collateralized loan obligations (CLOs) and a sense of protection offered by floating rate notes in a “rising rate environment” (or not, as the case may be).
Borrowers have tended to prefer leveraged loan structures, which typically come with far fewer covenants, allowing more operational flexibility for the issuing firm; over 75% of loans outstanding are classified as “cov-lite.” In addition to this, the issuers retain the ability to repay or refinance the terms of these loans at very short notice. A large part of loan activity, particularly this year, has been companies refinancing outstanding loans at lower margins.
There is a lot of overlap in the companies that issue high yield bonds and issue debt (loans), and it is no coincidence that the rapid increase in leveraged loans has coincided with a period of decline for high yield debt. Since the end of 2014, the U.S. high yield market has shrunk by 3.7% while the loan market has grown by 12.7%.
In aggregate, the combined size of the U.S. loan and high yield bond markets has been broadly stable since 2014 (Exhibit 2). Again, this is very different to the wave of mega leveraged buyouts (LBOs), which expanded the high yield and loan markets in the 2005 to 2007 period.
Exhibit 2: Combined Size of U.S. High-Yield and Loan Markets
Where Do We Go from Here?
There are many aspects of this credit and business cycle, which continue to surprise investors and differ from the textbook expectations of an aging bull market. Our guidepost for much of the divergence in behavior between European and U.S. corporations continues to be the experience of Japan in recent decades; erasing the memory of a debt trauma takes more than low interest rates.
In contrast, areas where we have observed a willingness to binge on debt in this business cycle are: emerging market corporates, U.S. investment-grade companies and the household sector in Australia and Canada. Each such debt boom presents different investment opportunities and risks.
Divergence remains the dominant theme for bond investors.
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Note: Yields and spreads quoted are correct at the time of writing in late October. Yields may vary and are not guaranteed.
* As of October 24, Source: Bank of America Euro Corporate Index
Credit Spread is the difference in yield between securities with similar maturity but different credit quality.
Basis Point (bp) equals 1/100 of a percentage point. 1 bp = 0.01%, 100 bp = 1%.
Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.
High yield or “junk” bonds involve a greater risk of default and price volatility and can experience sudden and sharp price swings.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.