High yield bonds showed resilience in the first half of 2018. Against a backdrop of equity volatility, rising interest rates and geopolitical risk, the asset class held up well, generating positive returns while most other fixed income securities posted losses. We remain positive on the asset class and believe four factors support the view that high yield remains attractive.
Constructive macro environment for high yield and other shorter duration risk assets
The macro environment for high yield bonds remains broadly supportive; solid economic growth, low unemployment, US tax reform benefits, modest corporate earnings growth, and low default rates paint a healthy backdrop for high yield and other shorter duration assets. With the passing of the 2017 tax cuts, we believe the US economy appears to have made a cyclical shift from a 2% to a 2.5%-3% GDP growth rate. Setting aside the longer-term sustainability of this growth, in the short-to-intermediate term, we believe tax reform is leading to continued tightening in the labor markets, increased demand for consumer and business services, a bump in consumer and business sentiment, and increased potential for stronger business investment. The high yield market primarily consists of domestic issuers, and the favorable US economic backdrop and strengthening dollar has been particularly beneficial to them. These factors have provided tailwinds for high yield credit, particularly lower-quality issuers, and has the potential to continue into 2019.
Additionally, while rising interest rates remain an obvious headwind for all fixed income assets, high yield has historically outperformed most other traditional fixed income assets, such as government and corporate credit, in a rising rate environment. As shown in Exhibit 1, year to date is no exception.
Exhibit 1: High yield total returns have historically outperformed as rates rise
One-year returns for each rising rate period when the 10-year US Treasury increased over 75 basis points over a trailing twelve-month period
January 1, 1985 – June 30, 2018
Source: US Treasury rates are from Bloomberg. Index returns are from Bloomberg Barclays indices. Past performance is not indicative of future results. Investments in high yield ("junk 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. The analysis above reflects the trailing 12-month return for the listed indices in time periods when the constant maturity 10-year US Treasury curve rate rose 75 basis points over a trailing 12-month period. The analysis does not include periods of rising rates (based on the prior 12-month rate change) if that rising rate environment occurs in the next twelve months. Production date: 7/17/2018.
Favorable micro backdrop for high yield issuers
Against a backdrop of strengthening GDP growth, improving corporate earnings and supportive capital markets, high yield issuer defaults, currently around 2%, are expected to remain low in the near term. Historically, the anticipation of increased defaults, typically during periods of economic weakness or recession, has led to high yield underperformance. Given the strength of capital markets in the first half of 2018, we believe defaults will remain anchored at or below historical averages over the next twelve months.
In addition, many high yield issuers are benefiting from increased demand for their goods and services while the recent tax cuts are boosting free cash flow. For companies within the energy and materials sectors, rising commodity prices have also been a positive. Therefore, as a whole, high yield issuers are currently generating significant year-over-year earnings and cash flow growth.
For issuers not benefiting from the current macro environment, capital markets remain open and willing to extend credit, or even equity, to many stressed issuers. For example, many lower-quality credits, such as Intelsat and Ceridian, have recently issued equity, while stressed credits, including Frontier Communications and Valeant Pharmaceuticals, have issued debt. Overall, the micro environment remains supportive for continued performance at the company level, and we expect the conditions to persist in the near term.
Despite outflows, technicals are still supportive
Ten years past the global financial crisis and well into one of the longest credit cycles on record, the high yield market remains disciplined. Market technicals are supportive and the types of behavior that often seed major credit problems are generally being avoided.
Market technicals have been a key component of high yield performance lately as supply remains historically low. US high yield new issuance is down 28%, year-over-year. Remarkably, the high yield market is likely to shrink for the fourth consecutive year. In addition, the largest use of new issuance financing remains refinancing, not LBOs, dividends or M&A activity. Yet, poor pricing and aggressive financing terms have not occurred despite the negative net issuance. For example, according to Barclays, on a year-to-date basis as of June 30, 2018, CCC-rated credits are increasingly pricing wide to initial price talk at the highest proportion since 2010.
Exhibit 2: High yield net supply is expected to shrink for the fourth consecutive year
US high yield net supply January 1, 1999 – June 30, 2018
Source: Barclays Research - June 2018 US High Yield Corporate Update. Annualization: Year-to-date multiplied by 12/month (including 1/2 for mid-months).
On the demand side, flows have been largely negative with approximately $45 billion exiting high yield mutual funds over the last two years. Contrary to popular opinion, we view the sizable and consistent retail outflows from the asset class as a favorable technical for the long-term health of the high yield market. While this may seem counterintuitive, high yield fund managers have generally been able to be more discerning with regards to capital deployment. As a counter-example, emerging markets and leveraged loan funds have seen significant and consistently positive inflows, forcing fund managers to be more aggressive in their investment allocations.
Valuations, although inside long-term averages, are not at extremes
While high yield proved more resilient than much of the fixed income universe in the first half of 2018, it didn't perform well on an absolute basis. The high yield yield-to-worst widened from approximately 5.7% in January 2018 to 6.5% as of June 30, 2018 (Exhibit 3) and total returns were only marginally positive. Spreads did perform modestly better, but still ended the second quarter 20 basis points wider on the year.
Although current spreads are inside long-term averages, they are not at the extremes witnessed in pre-recession tight environments. Notably, lower quality B and CCC credit are still wide of levels witnessed in 2007 and prior to the energy repricing in 2014. With a current dollar price below par ($98 as of June 30, 2018 relative to normal cycle highs of $104-105), we believe high yield has the potential, over time, to exhibit price appreciation.
Exhibit 3: High yield has widened by over 75 bps since January 2018
Bloomberg Barclays US Corporate High Yield Index – Yield to Worst (%)
January 1, 2018 – June 30, 2018
Overall, we believe current valuations are reasonable for high yield given the low default rate, relatively short duration, and coupon income that can offset fairly significant moves in underlying US Treasury rates, as has been witnessed thus far in 2018.
We maintain a constructive view of high yield and believe that if the current macro environment persists, the asset class is likely to continue to outperform traditional fixed income over the next year. Heading into the year, we outlined a base case of a 4-6% total return for the asset class in our 2018 high yield outlook. While that may seem optimistic at this stage, to the extent the worst of the US Treasury moves are behind us for the year, we still believe that the low end of the range is possible and maintain a constructive fundamental view on the asset class.
Past performance is not indicative of future results.
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