Economic News & Analysis—October 16, 2012
Too early to exit high yieldBy James Kochan, Chief Fixed-Income Strategist
The high-yield corporate bond market has continued to rally in 2012, producing a 12% total return through the first three quarters. Over the past three years, the market has produced an average total return of 12.5% per year. Over that time period, yields on 10-year B-rated bonds have declined from around 9% to around 6.5%. Today, yields in the 5.5% to 6.5% range for BB- and B-rated 10-year issues are at or near record lows—50 to 100 basis points (100 basis points equals 1.00%) lower than the previous record lows reached from 2005 to 2006.
This exceptional performance has been sustained by record inflows to high-yield mutual funds. In a low-yield world, investors seeking even a moderate amount of interest income have been drawn to high-yield mutual funds and exchange-traded funds. Because those inflows have been so strong, record volumes of new high-yield issues have been absorbed at exceptionally low yields.
Veteran observers of the high-yield markets have begun to express concerns about these and several other recent developments they regard as symptomatic of a frothy market. Contrarians regard investors chasing rallies as a warning that the rally is in its late stages. In addition, because demand is so strong, issuers have begun structuring new deals that expose investors to additional risks. For example, deals are being structured without the traditional bond covenants that prevent the company from issuing additional debt that would be senior in the capital structure—that is, companies could issue new debt that jumps ahead in line when it comes to getting paid. Several recent deals have included payment-in-kind bonds, sometimes called “PIK-bonds,” giving the company the option of making interest and principal payments with new bonds rather than cash. In previous cycles, bonds with these structures performed very poorly once the rally ended.
It is important to note, however, that two of the most reliable signs of trouble ahead are not in negative territory. Yield spreads to Treasuries are still quite generous, and default rates are still very low. Some observers worry that current spreads to Treasuries are no wider than the averages of the past 10 years. For example, the average spread for 10-year B issues is approximately 485 basis points, very close to the current spread. Those averages, however, are distorted by the explosion in spreads in 2007 and 2008. Without these extreme spreads, that average drops to around 400 basis points, or 75 basis points below the current spread.
A better comparison would be to the spreads reached in the most recent high-yield rally that lasted from 2004 into 2007. Because Treasury yields today are far lower than in 2005 and 2006, spreads to Treasuries are much wider now. For example, for 10-year maturities, spreads to Treasuries for BB and B credits are now approximately 425 basis points and 475 basis points, respectively. From 2004 to mid-2007, these spreads were 150 to 200 basis points narrower. There is, therefore, still considerable room for spreads to narrow from current levels before they would indicate heightened risk in the high-yield market.
Default rates also appear nonthreatening to the market. The Moody’s trailing 12-month default rate is now 3%, up from 1.8% a year ago but well below the long-term average of 4.8%. Moreover, spreads to Treasuries in past cycles were typically below current spreads and didn’t widen until the default rate moved above 6%. It would appear, therefore, that the pace of defaults is not warning of an end to the high-yield rally.
The unusual nature of this interest rate cycle is also important to the outlook for high-yield bonds. This cyclical recovery has been so much weaker than recoveries in past cycles that short-term rates are expected to stay low much longer than they did in earlier cycles. Those low short-term rates would be expected to help keep bond yields from moving sharply above current levels. The experience of 2004 to 2006 shows that bond yields can remain at or near cycle lows for long periods of time. While the high-yield market exhibited considerable volatility over those three years, it produced average annual returns of 8.3%. It was not until the onset of the financial crisis in 2007 that returns deteriorated.
Past cyclical experience also suggests that for high yield, recessions are much greater threats than periods of rising interest rates. Recessions bring financial stress and rising default rates, widening credit spreads, and poor returns from high-yield bonds. Currently, almost all leading indicators of economic activity are signaling continued moderate growth, not a recession, for the foreseeable future.
The bottom line for investorsIt is natural to become wary of a market that has rallied as much as high yield over the past three years. While it might be prudent to underweight the most risky sectors of the market after such a strong rally, it is probably too early to abandon the high-yield market entirely. A focus on shorter-maturity portfolios with limited exposure to the weakest credits would be a better risk-reduction strategy than to abandon the high-yield market. Key fundamentals such as yield spreads to Treasuries, default rates, and the outlook for the economy are suggesting that this market can continue to be the best-performing segment of the domestic bond market over the next 12 to 18 months. Total returns will probably not match those of the past three years, but they should continue to be substantially greater than returns from such “safe” sectors as cash equivalents and Treasuries. It is, in our view, still too early in this cycle to exit the high-yield market.