Few Signs of Stress Within High Yield

By

Summary

  • Fundamentals remain generally stable and high yield appears to be fairly valued, despite relatively low all-in yields.
  • We are monitoring shifting dynamics that could lead to a weaker consumer and lower operating margins, but we aren't seeing any near-term signs of stress.
  • With the surge in BBB issuance, fallen angel risk is top-of-mind for most. We believe the near-term downgrade risk is low and issuers are generally well-positioned to refinance upcoming maturities.
  • Distressed ratios have ticked up modestly in recent months, but remain well below the peak in 2016. Signs of stress remain isolated to certain industries.

What are your current views on high yield fundamentals?

High yield fundamentals have been fairly steady over the past year as management teams have limited debt growth, while EBITDA is up modestly. Most high yield companies are benefiting from the drop in rates and have been able to lower their interest costs through bond refinancing and floating rate loan adjustments. This has led to generally stable interest coverage ratios.

It is interesting to note that the high yield market, as represented by the Bloomberg Barclays US Corporate High Yield index, has the highest average credit quality – highest percentage of BBs and lowest amount of CCC & below – since October 2002 (Exhibit 1).

Exhibit 1: Credit quality composition of the high yield index

Source: Bloomberg Barclays US Corporate High Yield Index. Data from October 2002 to September 2019.

In addition, the index is near the shortest duration on record at 3.07 as of September 30, 2019 (Exhibit 2). This is important to keep in mind when comparing spreads historically as high yield is better quality and shorter duration than ever before. In other words, although yields are low, we view high yield as being fairly valued for the given level of risk.

Exhibit 2: Duration of high yield index declines to all-time low

Source: Bloomberg Barclays US Corporate High Yield Index. Data from October 2002 to September 2019.

Which financial metrics are you closely monitoring at this stage in the cycle?

We are paying close attention to operating margins. Revenue growth has slowed in 2019 as management teams have been hesitant to spend on capital expenditures, or capex, given US/China tariff tensions, Brexit uncertainties and global growth concerns. Many US high yield companies have been able to maintain operating margins through cost cutting efforts and with the help of lower commodity prices. The tightening labor market could start to put upward pressure on wage expenses, leading to lower operating margins and cash flows.

In general, the US consumer has been very resilient for the past several years. A strong job market, low interest rates and falling commodity prices, such as lower gasoline prices and decreased utility expenses, have led to a positive environment for the consumer. We are looking for any signs that the consumer is starting to pull back on spending. Given personal consumption makes up nearly 70% of US GDP, a weaker consumer could present problems for the economy.

Has the rise in outstanding corporate debt caused stress in the high yield market?

No, the increase in outstanding debt has not caused a significant increase in the distress ratios of US high yield issuers. The majority of new corporate debt issuance has been from high quality investment grade companies rather than high yield issuers. The outstanding high yield debt has not grown the past five years as debt levels hover around $1.2 trillion (Exhibit 3). Stable high yield debt has been the result of limited net new issuance, many private equity sponsor transactions getting funded in the leveraged loan market and a lack of fallen angels.

Exhibit 3: High yield corporate bond market growth lags BBBs

Source: Bloomberg Barclays US High Yield Index and Bloomberg Barclays US Corporate Index (BBB data). Data from July 2014 to September 2019.

That being said, within investment grade credit, the growth in corporate debt has been significant, increasing by 56% over the past five years, through September 2019. More importantly, BBB non-financial bonds have grown by 82% over this same timeframe. The growth in BBBs has been largely due to mergers and acquisitions, to fund share repurchases, and capex. As management teams recognized there are limited benefits of being an A-rated issuer versus a BBB issuer, they have become more aggressive in their optimal capital structure, resulting in a rise of BBB-rated debt.

As high yield managers, we pay close attention to BBBs as that market segment can have a significant influence on high yield market levels, especially if credit quality deteriorates. The combination of a weaker growth environment and an increase in fallen angels could be one scenario that may lead to a higher proportion of distress ratios in the high yield market. However, at this point, we believe the near-term downgrade risk is low as the economic backdrop remains generally supportive and corporate fundamentals are stable. In short, we don't believe the BBB credit bubble is ready to burst anytime soon.

Are you concerned about refinancing risk associated with upcoming maturities?

In addition to fallen angel risk, we keep a close watch on the upcoming maturity walls. During times of stress, particularly when the high yield markets become less liquid and new issuance comes to a standstill, those companies with near-term maturities are at risk of being unable to refinance these obligations, potentially triggering default. While there's been a slight buildup in front-end maturities in recent years, we believe the high yield market is positioned to withstand a typical market disruption. Most issuers have prudently termed out their maturity profile, reducing the risk that companies are unable to refinance near-term maturities.

Have you witnessed an increased in distressed bonds?

We define the distress ratio as companies trading below 70 cents on the dollar. Using this definition, distressed bonds have ticked up slightly to 4% since the recent September 2018 lows, but remain well below the peak of 19% in January 2016 according to JP Morgan (Exhibit 4).

The uptick in distress ratios is due to multiple dynamics including the decline in energy prices trading in late 2018, stress associated with China tariffs, opioid litigation in the pharmaceutical industry, potential healthcare policy shifts, wireline competition and heightened retailer deterioration.

Exhibit 4: Distressed bonds have modestly increased, but remain well below peak levels

Source: JP Morgan. Data from January 2010 to July 2019.

Which sectors or industries do you believe are most at risk of future distress?

In our view, the sectors most at risk of future distress include energy, healthcare, pharmaceuticals, retailers and telecom wirelines.

  • Energy remains a large part of the high yield market. Any deterioration in oil and natural gas prices could lead to an increase in defaults.
  • Healthcare includes a number of private equity companies that have relatively high leverage. Surprise billing legislation – a solution aimed to curb unexpected out-of-network charges for consumers – is likely to lead to lower revenue for several healthcare companies.
  • Pharmaceuticals have been under pressure from lower generic pharma pricing and potential opioid settlements.
  • Retailers – Department stores and specialty retailers have been under pressure from on-line retailers.
  • Telecom wirelines have been in slow decline as residential customers move to wireless.

However, each sector has its own risks and recent trends are not necessarily symptomatic of broader stress in the high yield market. The broader high yield market has remained resilient year to date against a backdrop of macro and geopolitical uncertainty. Looking forward, while we are cognizant of potential macro headwinds, we view the underlying fundamentals of the high yield market as remaining supportive in a slow but stable economic environment.

Disclosure

Past performance is not indicative of future results. This material is to be uses for institutional investors and not for any other purpose. This communication is being provided for informational purposes in connection with the marketing and advertising of products and services. This material contains current opinions of the manager and such opinions are subject to change without notice. Aegon AM US is under no obligation, expressed or implied, to update the material contained herein. This material contains general information only on investment matters; it should not be considered a comprehensive statement on any matter and should not be relied upon as such. If there is any conflict between the enclosed information and Aegon AM US' ADV, the Form ADV controls. The information contained does not take into account any investor's investment objectives, particular needs, or financial situation. Nothing in this material constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate to you. The value of any investment may fluctuate. Investors should consult their investment professional prior to making an investment decision. Aegon AM US is not undertaking to provide impartial investment advice or give advice in a fiduciary capacity for purposes of any applicable federal or state law or regulation. By receiving this communication, you agree with the intended purpose described above.

Results for certain charts and graphs are included for illustrative purposes only and should not be relied upon to assist or inform the making of any investment decisions.

Specific sectors mentioned do not represent all sectors in which Aegon AM US seeks investments. It should not be assumed that investments of securities in these sectors were or will be profitable.

Aegon AM US may trade for its own proprietary accounts or other client accounts in a manner inconsistent with this report, depending upon the short-term trading strategy, guidelines for a particular client, and other variables.

There is no guarantee these investment or portfolio strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest over the long-term, especially during periods of increased market volatility.

Investments in high yield bonds may be subject to greater volatility than fixed income alternatives, including loss of principal and interest, as a result of the higher likelihood of default. Value of these securities may also decline when interest rates increase.

This article contains forward-looking statements which are based on the firm's beliefs, as well as on a number of assumptions concerning future events, based on information currently available, and are subject to change without notice. These statements involve certain risks, uncertainties and assumptions which are difficult to predict. Consequently, such statements cannot be guarantees of future performance and actual outcomes and returns may differ materially from statements set forth herein.

Aegon Asset Management US is a US-based SEC registered investment adviser and is also registered as a Commodity Trading Advisor (CTA) with the Commodity Futures Trading Commission (CFTC) and is a member of the National Futures Association (NFA). Aegon Asset Management US is part of Aegon Asset Management, the global investment management brand of the Aegon Group.

Recipient shall not distribute, publish, sell, license or otherwise create derivative works using any of the content of this report without the prior written consent of Aegon USA Investment Management, LLC, 6300 C Street SW, Cedar Rapids, IA 52499. ©2019 Aegon Asset Management US. Ad Trax: 2792373.1 Exp Date: 10/15/2020

Ben Miller, CFA

About Ben Miller, CFA

Ben is co-head of high yield and a portfolio manager responsible for US and global high yield trading and portfolio management.