PM Perspectives: Our Positive Prognosis for High Yield
In this video, Portfolio Manager Seth Meyer discusses the latest in high-yield fixed income, including how the market has changed and the current health of fundamentals and technicals within the sector. He also shares some strategies he believes can help generate yield while dampening volatility.
- From a credit ratings and credit metrics perspective, we may be in a better place than 2007-2008 despite the fact that valuations are starting to approach similar levels.
- In the high-yield market today, credit fundamentals and technicals are solid, and we think U.S. high yield remains relatively healthy.
- In a market where credit spreads are relatively tight, generating yield without pushing the risk envelope becomes challenging; one of the possible ways to do this is by moving up the capital structure.
Seth Meyer: I think it’s very easy to look at spreads as your measure of volatility and your measure of valuation when you’re looking at the high-yield market, because that’s generally where you’re going to start. How much additional yield am I going to get above the Treasury for buying this company? I think one of the things that gets lost in that sort of an evaluation and that sort of just paint brushing the market is the market itself has evolved significantly over the past 10 years. Entering the financial crisis, the percentage of CCCs that were in most indices was somewhere between 800 to 1,000 basis points higher going into the financial crisis than we have today. So generally speaking, you can make the argument that from a credit ratings perspective and a credit metric perspective, we may actually be in a better place today than we were in 2007 and 2008, despite the fact that valuations are starting to approach those levels. You can make the argument that we certainly should, just because of the improvement that we started to see in just high-yield companies in general here in the U.S.
In the high-yield market today, credit fundamentals are actually really solid. As you look at what’s happening with corporate credit and corporate leverage, it’s actually been declining over a period of time. Part of it is, you know, just CFOs’ conservative nature, part of it is the quality bias that I mentioned in the index being a little more higher quality than it’s been in the past, but we’re starting to see behavior that is actually very healthy in terms of credit fundamentals. Interest coverage also remains very strong, and free cash flows and percentage of debt is increasing because of the corporate tax reform that we’ve seen enacted this year, so there’s a lot of reasons to be optimistic and positive with what’s happening with credit fundamentals, and I think it’s one of the reasons why corporate high-yield spreads remain trading in a relatively tight range. There’s no obvious signals that we’re entering a default cycle. There’s no obvious sectors that we sit back and really worry about like we did in 2015 and 2016 with oil, and thinking about what was happening with the environment with what we were seeing then. The only places that we’ve seen some shakiness over the past 18 months, really, has been in retail, and retail to a certain extent is so small as a percentage of the U.S. high-yield index that even if they all were to default tomorrow that the default rate would go up, clearly, but it wouldn’t be to the degree that we were talking about with the oil and the gas and metal and mining companies that we were seeing in 2015, 2016. So, you know, as we sit back and look 12 or 18 months into the future, if the economy remains where it’s at and U.S. companies continue to do what they’re doing, from a credit fundamental perspective, we think the U.S. high-yield market actually remains relatively healthy.
The technical picture … so we had mentioned the fundamentals of high-yield being relatively healthy. The technical picture of the high-yield market, actually even, you can paint a picture that it’s even stronger than what we’re seeing on the fundamental side, so for the second straight year in 2018, we’re going to see the aggregate U.S. high-yield index actually shrink in total bonds outstanding. So it basically means more bonds are being refinanced and paid back than being reissued. That is a very strong technical picture considering a U.S. high-yield manager gets paid a yield of whatever the high-yield index is, 5% to 5½%. If you don’t want your cash balance to rise, you have to reinvest that capital. All of us are getting 5% to 5½% of yield; we have to take that cash and reinvest into a shrinking market in aggregate size, which is a very strong technical picture. So when you sit back and you look at the fundamentals, check, they look fine. U.S. high yield looks great. The technical picture looks just as solid. I’d mentioned the default rate being very benign, so you can really sit back and think to yourself, “All right. Where corporate credit spreads are, which are very tight to historic norms, might be justified as to what we’re seeing with fundamentals and technicals right now on high yield.”
In this market where credit spreads are relatively tight, generating yield without pushing the envelope and risk becomes pretty challenging. So one of the ways to do it is really to move up in the capital structure, so rather than own the unsecured bond of whatever company you’re evaluating, look at the relative value difference between moving up in the capital structure and buying a senior secured bank loan, which gives you a couple advantages. One, it’s secured in the capital structure, so what that means is you have hard assets of the business actually backing up that loan itself. Two, they’re floating rate in nature, so as the Fed continues to raise rates, you’re just going to clip a little higher yield. So that’s one of the simpler ways to actually one, it upgrades the portfolio, and two, delivers yield and hopefully, through market environments, it would dampen your volatility. The other thing you can do is shorten your duration and just move in on the maturity stack of that individual company, so rather being invested in the 2025 or 2026 maturity, move in to the 2022 or the 2021. You’re going to give up yield by going from a longer-duration asset to a shorter-duration asset, that’s true, but you should be able to dampen your volatility. You’re exchanging one risk, which has a little more interest rate risk, because you’re 10 years in duration, not eliminating it completely, but dampening that volatility by buying the shorter bond. You should still be able to generate yield, dampen your volatility and help your overall portfolio achieve your yield goals.
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.
Bank loans often involve borrowers with low credit ratings whose financial conditions are troubled or uncertain, including companies that are highly leveraged or in bankruptcy proceedings.
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 bps = 1%.
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