- Current high yield spread levels occur infrequently, presenting a potential buying opportunity for long-term investors.
- Historically buying into this market weakness has resulted in strong subsequent returns as spreads above 800 basis points have led to average annualized returns over the next 12 and 24 months of 30.3% and 21.6%, respectively, over the last 25 years.
- Markets will likely remain volatile in the short term, but we expect high yield to outperform long-term averages when the economy rebounds.
Unprecedented times, attractive high yield valuations
The coronavirus crisis and subsequent economic weakness fueled a fear-induced sell-off in the high yield markets as spreads widened over 700 basis points in a matter of weeks. The velocity of the movement was unprecedented, with US high yield spreads widening past 1000 basis points. While spreads have tightened since the recent peak, as of March 26 the option-adjusted spread was around 950 bps. Typically these spread levels present themselves about once every 10 years (Exhibit 1). In the past when valuations declined by this magnitude, the subsequent recovery was significant with markets posting above-average total returns.
Exhibit 1: Historical monthly US high yield spreads
Source: Bloomberg Barclays as of March 26, 2020. Includes monthly option-adjusted spreads for the Bloomberg Barclays US Corporate High Yield Index from January 1994-February 2020 and daily data as of March 26, 2020.
Cheap valuations may lead to strong returns
Historically, when high yield spreads have crossed over 800 basis points, the average annualized returns over the next 12 and 24 months were 30.3% and 21.6%, respectively, based on the Bloomberg Barclays US Corporate High Yield Index (index) data over the last 25 years (Exhibit 2).
Exhibit 2: US high yield spreads over 800 basis points and subsequent returns
|Trailing 12 months||Trailing 24 months|
|Number of positive return periods||21/23||23/23|
|Number of negative return periods||2/23||0/23|
Source: Bloomberg Barclays as of February 28, 2020. Past performance is not indicative of future results. Based on monthly data for the Bloomberg Barclays US Corporate High Yield Index from January 1994 to February 2020. Reflects the trailing 12- and 24-month annualized returns following periods when the index option-adjusted spread increased above 800 basis points at month end.
For an asset class with an average annual return of about 9% over the last three decades, current valuations and potential subsequent total returns are compelling. Notably, a negative annual index return has historically been followed by a meaningful positive annual return in the subsequent year (Exhibit 3).
Exhibit 3: US high yield annual returns
Source: Bloomberg Barclays as of March 26, 2020. Past performance is not indicative of future results.
Markets will likely remain volatile in the short term as they find a bottom, but we expect high yield to outperform long-term averages when the economy rebounds. Also, liquidity, while improving gradually, remains challenged.
Fundamentals are weakened
Coming into this crisis, fundamentals were generally solid and the economic backdrop was sound. That quickly reversed as the pandemic caused panic in the financial markets and entire industries went dark almost overnight.
With a large portion of the US economy effectively shut down, it's now clear that a sharp contraction in economic activity is upon us. Further, plummeting oil prices have weighed heavily on markets, most notably high yield debt. Given the fluidity of macro-level events and the lack of a clear coronavirus resolution, it is challenging to pinpoint the duration and severity of the recession. At this point, we believe we will see at least 1-2 quarters of negative US GDP growth and a sharp spike in unemployment.
While the fundamentals in certain industries appear bleak right now, we are encouraged by the belief that the majority of high yield companies have adequate liquidity and balance sheets that are generally termed out beyond the next couple of years. So while fundamentals have turned in the short term, and we anticipate leverage to spike higher for many companies, we do think the vast majority of companies have the wherewithal to survive until the economy rebounds. We also think the recently passed fiscal and monetary stimulus has the potential to shorten the duration and severity of this downturn, although that will depend on length of time the COVID-19 virus plagues the US economy.
Undoubtedly, the consumer-oriented sectors have felt a disproportionate impact and companies are still very much reacting to the changing environment every day. On the positive side, many of these companies were in a relatively healthy spot coming into this crisis. Many of these consumer-oriented and travel-related companies are struggling with near complete shutdowns and uncertainty surrounding fiscal stimulus and potential government support.
We anticipate some of these industries will receive assistance from the government. Additionally, it's encouraging to see companies take prudent and proactive approaches to accessing and shoring up liquidity to help bridge the gap.
In the near-term, our analysts are stress-testing companies to make sure they don't run into any near-term liquidity crunch even absent some loan assistance.
The energy sector has been in the cross-hairs as the combination of weakening demand and a Saudi/Russia price war shook the markets. As crude oil has fallen to levels last seen in early 2000s, sentiment around the energy sector has never been worse. Within the energy sector, independent energy and oil field services have experienced the greatest spread widening as the credit outlook for these industries looks bleak at current oil and gas prices.
Downgrade and default expectations have increased, but much of this is being reflected in prices. The average dollar price of high yield energy bonds is trading at half of par value, or around $50, with a yield to worst over 20% as of March 26. This includes the midstream segment, which accounts for approximately 40% of the high yield energy sector, and consists of companies that have historically been viewed as stable given the contractual, recurring fee-based revenues. Given this, we believe many of these midstream companies will be relatively resilient, even in a low commodity price environment. As a result, we do not anticipate high default rates from the midstream segment.
Default risk is rising
As the coronavirus infection rate continues to climb and containment efforts halt business activity, the likelihood of increased corporate default activity seems unavoidable. Using basic assumptions, one can infer implied default rates from current spreads. Based on spreads as of March 26, the current market is pricing in a 12-month default rate of about 10.5%, and excluding the energy sector, a default rate of over 8.5%. For context, global leveraged finance defaults reaching 13% during the financial crisis according to Moody's. We expect defaults to move higher and likely end the year below these market-implied levels. In particular, we believe the ex-energy implied default rate of 8.5% looks especially high.
At this juncture it is challenging to predict next quarter's earnings, particularly as we are unsure of the duration of the shutdowns and future government responses. But we see very few triggers or reasons why the vast majority of high yield companies would file bankruptcy in 2020.
Current high yield spread levels present themselves infrequently and historically buying into this market weakness has resulted in strong subsequent returns. Markets will likely remain volatile in the short term, but we expect high yield to outperform long-term averages when the economy rebounds.
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