Gaining perspective on the U.S. high yield bond market
The last couple of months have been quite volatile for capital markets – and bond markets1 were certainly no exception. Below is a summary of our latest thoughts on the recent turbulence in high yield markets.
The Fed Awakens
After seemingly endless discussion over the inevitably of rising interest rates, to a chorus of yawns, the Fed finally raised the Fed Funds rate by a quarter point in December. Market reaction was muted immediately following the Fed’s decision and interest rates across the yield curve were little changed as markets had largely priced in the move at the front end of the yield curve. Longer term rates didn’t move much either given other market dynamics (e.g. low inflation expectations, decreasing interest rates outside the U.S. and rising credit spreads) at play. While the Fed stole the headlines, the real action in the bond market was happening elsewhere: in high yield credit markets.
Biting at the apple in credit
The U.S. high yield market has been on a roller coaster ride over the past year.2 Several factors contributed:
- The price of oil
The precipitous fall in oil prices has put the business models of many companies in the energy sector under stress. Given the energy sector represents over 10% of the high yield market,3 it’s no surprise that low oil prices have hurt the broader high yield market.
- Limited access to credit
Access to credit for the lowest rated borrowers, irrespective of the issuer’s industry, has essentially been cut off in recent months.4 This is a marked shift from 2015, in which $260 billion5 in new high yield bonds were issued. This signals that buyers have been less willing to assume risky debt and borrowers are finding it less attractive to issue at higher interest rates.
- Illiquid secondary market
Regulatory changes following the financial crisis of 2008 have removed investment banks from holding bond inventories, which has contributed to lower liquidity across the credit markets. This phenomenon has been particularly pronounced in the high yield market. With fewer natural buyers in the marketplace, many sellers have had to accept lower bids from potential buyers.
As a result, by January 2016, high yield bond spreads rose to levels that are typically unsustainable for any length of time. Point in case: on January 20th, the U.S. high yield average spread6 closed at 790 basis points over Treasuries.
To put this into perspective: the high yield market has only broken through that level 5 times in the last 12 years.7 In all 5 of those historical cases, investing in high yield immediately when the spread widened beyond 790 produced a positive return over the next 2 years with cumulative returns ranging from 4% to 48% and an average cumulative return of 27%.
As such, we’ve been observing managers we research actively rotating portfolios toward high yield credit. In addition, some managers have increased allocations to areas such as European bank capital and midstream energy, which despite the recent negative news headlines, we believe these sectors appear to be some of the most attractively priced parts of the market for the risk that they represent.
Where’s the diversification?
Of course, the bond market is composed of more than simply credit and there is merit to diversifying sources of return within the fixed income portion of an overall portfolio.
In particular, we believe some attractive opportunities exist in the relative value currency space for investors with commensurate risk tolerance. Specifically, among commodity currencies, the Canadian dollar appears significantly undervalued, while the Australian and New Zealand dollars seem to be among the most overvalued currencies in G10.8 Similarly, within currencies that typically do well when markets retreat, the Japanese Yen currently appears undervalued, while the Swiss franc seems highly overvalued.
1 Represented by the Barclays U.S. Aggregate Bond Index as of 1/29/2016.
2 Represented by the Barclays U.S. Corporate High Yield Index as of 1/29/2016.
3 Represented by the Barclays U.S. Corporate High Yield Index as of 1/29/2016.
4 Source: Annual, quarterly and monthly U.S. Corporate Bond Trading Volume from 2005 to January 2016 sourced from Securities Industry and Financial Markets Association (SIFMA). Accessed on Feb 3, 2016.
5 Source: Securities Industry and Financial Markets Association (SIFMA).
6 Spreads are represented by the average option-adjusted spread on the Barclays U.S. Corporate High Yield Index over Treasuries.
7 Based on quarterly option-adjusted spread levels of the Barclays U.S. Corporate High Yield Index from 03/31/1994 to 12/31/2015.
8 G10 refers to The Group of Ten – the 11 countries (Belgium, Canada, France, Germany, Italy, Japan, the Netherlands, Sweden, Switzerland, the United Kingdom and the United States) that co-operate on global financial matters.
Barclays U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (specifically: Barclays Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index).
Barclays U.S. Corporate High Yield Index: an unmanaged index considered representative of fixed-rate, noninvestment-grade debt.
Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries.
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