Does Market Volatility Offer Opportunities For High Yield Bonds?
Does Market Volatility Offer Opportunities For High Yield Bonds? by Jennifer Ponce de Leon, Columbia Threadneedle Investments
- We believe that the recent volatility and massive sell-off of US high yield offers an attractive relative investment opportunity, as yield premiums have broadened to provide appropriate compensation for current market risks.
- The overall market still warrants a cautious approach for 2016, but we are constructive on a large part of the set of high yielding non-commodity opportunities.
- A disciplined credit selection process should help investors take advantage of high yielding opportunities.
High Yield has become a very forked market with few issues trading at or near the market median. Energy, metallurgical and mining companies are under significant pressure, yielding significantly more than the index, but face the prospect of very high defaults over the next two years. The universe of non-commodity high yield bonds has broadened in sympathy, trading mostly at yields well below the index, but offering much better risk-adjusted opportunities with a weaker default outlook. . We believe a yield premium of 7% (+700 basis points vs. Treasuries) excluding struggling energy, metals and mining industries are an attractive entry point. This provides an additional 2% return cushion to long-term averages for investing in high return. The market is now approaching that level as the high yield sell-off has widened beyond energy, making core high yield (excluding commodities) more attractive.
2016 continues to offer investors largely the same set of challenges as 2015. However, this year had a different valuation starting point for high yield, which provides additional compensation for these risks. Absolute returns will largely depend on two factors:
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- the resilience of the US economy and the feedback loop of stalled global growth, and
- market reaction to divergent central bank policies and less aggressive capital markets
Note that the second factor could lead to greater caution on the part of company management teams and the resulting impact on company growth. However, some relative return opportunities are starting to emerge. We remain cautious about the risks facing the asset class, but constructive on much of the set of high yield non-commodity opportunities. Credit fundamentals remain adequate and support the asset class with reasonable earnings growth, low default rates, access to capital at reasonable rates and strong but shrinking enterprise value multiples underlying debt levels.
Additionally, history has shown that the high yield securities market has not experienced consecutive negative annual total returns. However, there have been successive years of modest returns in uncertain environments, the most relevant example being the period 2000-2002 (Figure 1). Finally, we continue to view high yield as attractive relative to equities, especially as high yield companies generate a greater proportion of their income in the US and anticipate more weakness. But for all of our analysis, we are increasing caution on the higher beta portion of the market and do not believe this is the time to stretch return or achieve return by adding significant risk to the portfolio in the future. the industries most in difficulty or the lowest quality levels. .
Chart 1: High yield has not posted consecutive negative annual returns
Source: JP Morgan, as of December 31, 2015.
Relative value opportunities
While there are downside risks, we believe the current valuations of the asset class have incorporated many of these risks. As of January 20, 2016, the valuations of the high yield bond market according to the Merrill Lynch US High Yield Cash Pay Constrained Index stood at 9.69% at worst return (YTW) and +819bp at spread. worse (STW). Yields are 101bp higher and spreads have been 130bp wider since December 31, 2015 and have reached levels not seen since October 2011, when yields and spreads peaked at 9.85% and +875bp , respectively.
Excluding the energy / metals / mining sectors, the spreads are at +680 bps, for a yield of 8.30%, or around 180 bps wide compared to the historic median of 500 bps. This underlines the continued importance of calibrating index valuations to the exclusion of the two components affected by falling commodity prices.
Based on historical risk premiums, high yield now anticipates a default rate of 7.6% in 2016 compared to our expectations of a default rate of 5.5%. The “core” of the non-commodity market assesses a default rate of 6.0% compared to our expectations for a default rate of less than 3.0%.
Table 2 & 3: Valuations offering additional compensation for risk
High efficiency: worst-case propagation
Source: BoAML, as of January 20, 2016.
High yield: yield at worst
Source: BoAML, as of January 20, 2016.
Relative to stocks, the market for high yield securities appears to provide additional compensation for the risks they face today. As high yield bond spreads approach levels last seen in 2011, when the market anticipated a global recession, the S&P 500 has retreated to levels seen in August / September 2015 and remains only 11% in below its all-time high.
Chart 4: Is High Yield Pricing Lower Than Equities?
High Yield: spreads vs S&P 500
Source: BoAML, Bloomberg, as of January 20, 2016.
Technical factors: Flow and supply
Technical data, while mixed, continues to support the asset class. High yield experienced a third consecutive year of outflows in 2015 and this trend continued in 2016. Outflows are partially offset by lower issuance, which is expected to continue to decline in 2016, as we believe that ‘there will be fewer opportunistic refinancings due to higher market rates and stricter underwriting standards.
The maturities of high-yield bonds remain manageable over the next few years given the amount of refinancing that has taken place in recent years, with management teams taking advantage of historically low interest rates. Only 15.5% of high yield bonds and leveraged loans mature in the next three years, up from around 22% at the end of 2011.
Chart 5: Manageable maturities in the high yield market
High Yield Bonds and Loans Maturity
Given reasonable fundamentals, limited refinancing risk, low levels of overall leverage, and reasonable earnings prospects, we still view high yield as an attractive investment alternative to equities. We remain cautious about the upper beta of the market. Therefore, we do not believe this is the time to optimize return or to achieve return by adding significant risk to the portfolio.
By positioning themselves for stable and improving credit situations, avoiding credits with deteriorating fundamentals, and remaining disciplined in terms of compensation for risk taking, we believe active managers can generate strong risk-adjusted returns. in 2016. A disciplined credit selection process based on solid fundamentals, rigorous risk analysis and management should serve investors well to take advantage of the opportunities that have been dragged down with the broader market.