High yield Bonds: An Investment opportunity post 2008
economic crisis
Post 2008 economic crisis, High yield bond market has
evolved significantly in terms of returns generated to investors, as they have
been quite rewarding, if they went long and held it to 7 years. There are few
exceptions in last quarters on 2015 and Current 2016 Q1, but period prior to it was remarkably
rewarding time for investors in this asset class. From March 31, 2009 to June
30, 2014, the high yield market returned nearly 18% on an annualized basis,
with spread to worst dropping from 1,675 basis points to 372 basis points over
comparable Treasury bonds (Please refer figure 1)
Figure 1[1]
[1]
Source : S&P Capital IQ LCD, SPUSCHY stands for S&P U.S. Issued High
Yield Corporate Bond Index
Return of High Yield bonds encompasses two components:
Coupon Income and price change. Coupon being major return driver, also serves
as cushion to price volatility of the asset class over the time, which in turn
generates strong risk adjusted returns over long period. With respect to
different phases of business cycle, high yield bond asset class has been proved
to be useful and more rewarding at mid cycle expansions amid strong credit and
profit growth. It is useful in for de-risking growth-heavy portfolios – through
high yield investors can capitalize on the latent phase of the cycle,
benefiting from attractive carry while also being better protected on the
downside.
With respect to comparison between High yield bond asset
class to Investment grade bonds at different cycle phases, Fidelity investments
has provided interesting graph as part of their research report published in Q3
2015 ( Please refer figure 2 ).
Source; using data from indices from: Bank of America Merrill
Lynch, Barclays. Source: Fidelity Investments (AART), as of 6/30/15.
Putting high yield bonds against equities, interesting
observation of out performance of this asset class is evident in some cases when
growth assets faltered (Please refer figure 3[1]).
This makes them a compelling alternative to equities, given their continued
attractive yields of the asset class and better downside protection offer. It’s
been less compelling in recent years however as equities outperformed. As per
research done at London based firm named “ETF Strategy”, it has been found that
equities took twice as long as high-yield bonds to regain their losses after
the financial crisis, and equities also took nearly seven years to regain the
cumulative returns of high-yield[2].
Figure 3
[1]
Source: Fidelity International, Bloomberg, BofA Merrill Lynch US High Yield
Master Index, Oct 2015
With regard to issuance of high yield bonds and respective
returns over the years, high-yield market matured through increasing new bond
issuance, which reached a peak of $287 billion in 2010 (Source: S&P Capital
IQ LCD). With the ongoing new issuance weighed against maturing bonds and other
bond take-outs, the market has held around approximately $1 trillion, according
to Bank of America Merrill Lynch. Figure 4[1]
shows the overall trend of issuance volume over the years. As crude oil prices
have been continued under pressure, it affected the high yield bond issuance in
Q1 2016. Issuance during the first three months of the year totaled $36.1
billion, down dramatically from the $91.6 billion during the first quarter of
2015 (Source: SIFMA). The 1Q 2016 total is the least since the fourth quarter
of 2011.
Figure 4
[1]
Source : S&P Capital IQ LCD, SPUSCHY stands for S&P U.S. Issued High
Yield Corporate Bond Index
With respect to trend data on historical US junk bond (High
yield bonds) yields, there was long period in decline following the crash of
2008-09 till 2014 Q2. Due to volatility in Europe and worries regarding the end
of quantitative easing in the US (and about rising rates generally), market
began to turn after 2014 Q2, resulting the yield topping 10% at the end of 2015
Q4 (Please refer Figure 5[1])
Figure 5
[1] Source : S&P Capital IQ LCD, SPUSCHY stands for S&P U.S.
Issued High Yield Corporate Bond Index
High yield Bonds: An Investment opportunity post 2008 economic crisis
[1]
Source : S&P Capital IQ LCD, SPUSCHY stands for S&P U.S. Issued High
Yield Corporate Bond Index
Return of High Yield bonds encompasses two components:
Coupon Income and price change. Coupon being major return driver, also serves
as cushion to price volatility of the asset class over the time, which in turn
generates strong risk adjusted returns over long period. With respect to
different phases of business cycle, high yield bond asset class has been proved
to be useful and more rewarding at mid cycle expansions amid strong credit and
profit growth. It is useful in for de-risking growth-heavy portfolios – through
high yield investors can capitalize on the latent phase of the cycle,
benefiting from attractive carry while also being better protected on the
downside.
With respect to comparison between High yield bond asset
class to Investment grade bonds at different cycle phases, Fidelity investments
has provided interesting graph as part of their research report published in Q3
2015 ( Please refer figure 2 ).
Source; using data from indices from: Bank of America Merrill
Lynch, Barclays. Source: Fidelity Investments (AART), as of 6/30/15.
Figure 2
Putting high yield bonds against equities, interesting
observation of out performance of this asset class is evident in some cases when
growth assets faltered (Please refer figure 3[1]).
This makes them a compelling alternative to equities, given their continued
attractive yields of the asset class and better downside protection offer. It’s
been less compelling in recent years however as equities outperformed. As per
research done at London based firm named “ETF Strategy”, it has been found that
equities took twice as long as high-yield bonds to regain their losses after
the financial crisis, and equities also took nearly seven years to regain the
cumulative returns of high-yield[2].
Figure 3
[1]
Source: Fidelity International, Bloomberg, BofA Merrill Lynch US High Yield
Master Index, Oct 2015
[2]
Source: ETF Strategy, “US high-yield bonds “compelling substitute” for
equities, says ETF issuer Source” , http://www.etfstrategy.co.uk/us-high-yield-bonds-compelling-subsitute-to-equities-finds-etf-issuer-source-39478,
accessed on Apr 24 2016,
With regard to issuance of high yield bonds and respective
returns over the years, high-yield market matured through increasing new bond
issuance, which reached a peak of $287 billion in 2010 (Source: S&P Capital
IQ LCD). With the ongoing new issuance weighed against maturing bonds and other
bond take-outs, the market has held around approximately $1 trillion, according
to Bank of America Merrill Lynch. Figure 4[1]
shows the overall trend of issuance volume over the years. As crude oil prices
have been continued under pressure, it affected the high yield bond issuance in
Q1 2016. Issuance during the first three months of the year totaled $36.1
billion, down dramatically from the $91.6 billion during the first quarter of
2015 (Source: SIFMA). The 1Q 2016 total is the least since the fourth quarter
of 2011.
Figure 4
[1]
Source : S&P Capital IQ LCD, SPUSCHY stands for S&P U.S. Issued High
Yield Corporate Bond Index
With respect to trend data on historical US junk bond (High
yield bonds) yields, there was long period in decline following the crash of
2008-09 till 2014 Q2. Due to volatility in Europe and worries regarding the end
of quantitative easing in the US (and about rising rates generally), market
began to turn after 2014 Q2, resulting the yield topping 10% at the end of 2015
Q4 (Please refer Figure 5[1])
Figure 5
[1] Source : S&P Capital IQ LCD, SPUSCHY stands for S&P U.S.
Issued High Yield Corporate Bond Index
Current Environment
A few growing signs of trouble were seen in high-yield debt
post second quarter of 2015 due to a few macro-economic factors, current oil
prices slump and subsequent default worries. Returns in 2015 through Dec. 14
are negative 5.15%, which made investors worrisome. They fear that weakness in
oil and commodity sectors will “spill over” into the broader credit universe.
- As per Morningstar data just 17 out of 184 US high-yield funds turned in a positive performance before fees in 2015, making it the worst 12 months for high-yield fund managers since the financial crisis.
- Fewer than 1 in 10 US high-yield bond funds delivered positive returns last year due to crude oil’s sharp price decline and uncertainty over the outlook for US interest rates (Source: Morningstar data)
- Rating downgrade to upgrade ratio for speculative grade companies is 2:1, worst ratio since 2009.
- Oil spill over effect may exert pressure across the rest of the US high-yield market into other sectors, such as transportation, capital goods and commercial services.
Dissection of problems related to Default rising and Oil
price slump, both hurting the Investors’ confidence in high yield bond market,
is the need of the hour.
Default
There is a positive
correlation between Speculative grade default rate and US real GDP growth as
evident by Figure 6[1].
Figure 6
Although it is highly likely
that commodity related sectors may face the burnt in terms of default rising,
but overall liquidity of other corporate sector in US is sufficient enough to
avoid defaults, though they may face missed coupon payments at times.
Moody’s Investors Services projects that default rates will
raise to 3.4% over the next year, versus 2.3% over the past 12 months (Figure 7[1]),
which is far below than average default rate of 4.5% over the past 25 years.
Figure 7
[1]
Source: Moody’s, Aug 2015
Oil
Price Slump
In Dec 2015, Organization of
Petroleum Exporting Countries (OPEC) announced that its members will continue
to pump approx. 31.5 million barrel of crude oil per day to protect their
market share despite glut. Due to this announcement, oil prices tumbled,
falling below $35 per barrel in Dec 2015 and reaching the lowest price since
2008. This price was far below than benchmark of $40 per barrel. This factor
along with 25 basis point increase in Interest rate by U.S. Federal reserve,
slowing economic growth in China and other emerging economies, made a ripple
effect on annual performance of risk assets of US in Dec 2015. This resulted in
weakest performance of risk assets post 2008 financial crisis. The energy
sector in US accounts for nearly 15% of high yield bond issuance, As per SIFMA
data. Same portion is accounted from companies in metal and mining where
commodity prices are also collapsing. Consequences of this oil price slump are
already evident in the form of a wave of credit downgrades and a flurry of
defaults in energy sector is US.
Figure 8
The Oil spillover effect too
raises big concerns on investors as other sectors like transportation, capital
goods and commercial services are going to be impacted due to repricing of
energy bonds.
- As per Morningstar data just 17 out of 184 US high-yield funds turned in a positive performance before fees in 2015, making it the worst 12 months for high-yield fund managers since the financial crisis.
- Fewer than 1 in 10 US high-yield bond funds delivered positive returns last year due to crude oil’s sharp price decline and uncertainty over the outlook for US interest rates (Source: Morningstar data)
- Rating downgrade to upgrade ratio for speculative grade companies is 2:1, worst ratio since 2009.
- Oil spill over effect may exert pressure across the rest of the US high-yield market into other sectors, such as transportation, capital goods and commercial services.
Dissection of problems related to Default rising and Oil
price slump, both hurting the Investors’ confidence in high yield bond market,
is the need of the hour.
Default
There is a positive correlation between Speculative grade default rate and US real GDP growth as evident by Figure 6[1].
Figure 6
It is highly unlikely to say US is heading towards recession
going by current macroeconomic factors and recent federal move of rate hike.
Volatility in high yield market is very far from distress experienced at the
height of the financial crisis. Average prices of non-commodity sectors in the
high-yield corporate bond market are trading at 93 percent of par, on average.
In October 2008, every sector except utilities was trading below 80 percent of
par, on average (Source: High-Yield and
Bank Loan Outlook | Q1 2016 Guggenheim Investments)
[1]
Source: Fidelity International, Bloomberg, Moody’s, Sep 2015
Although it is highly likely
that commodity related sectors may face the burnt in terms of default rising,
but overall liquidity of other corporate sector in US is sufficient enough to
avoid defaults, though they may face missed coupon payments at times.
Moody’s Investors Services projects that default rates will
raise to 3.4% over the next year, versus 2.3% over the past 12 months (Figure 7[1]),
which is far below than average default rate of 4.5% over the past 25 years.
Figure 7
[1]
Source: Moody’s, Aug 2015
Oil Price Slump
In Dec 2015, Organization of
Petroleum Exporting Countries (OPEC) announced that its members will continue
to pump approx. 31.5 million barrel of crude oil per day to protect their
market share despite glut. Due to this announcement, oil prices tumbled,
falling below $35 per barrel in Dec 2015 and reaching the lowest price since
2008. This price was far below than benchmark of $40 per barrel. This factor
along with 25 basis point increase in Interest rate by U.S. Federal reserve,
slowing economic growth in China and other emerging economies, made a ripple
effect on annual performance of risk assets of US in Dec 2015. This resulted in
weakest performance of risk assets post 2008 financial crisis. The energy
sector in US accounts for nearly 15% of high yield bond issuance, As per SIFMA
data. Same portion is accounted from companies in metal and mining where
commodity prices are also collapsing. Consequences of this oil price slump are
already evident in the form of a wave of credit downgrades and a flurry of
defaults in energy sector is US.
The question is whether high
yield bond prices are highly correlated to oil prices. The answer is quite
evident from research report published by Credit Suisse, which shows high
degree of correlation (Figure 8)[1]. This is further affecting the performance of
high yield bond market, resulting in further volatility in market in the near
term.
Figure 8
The Oil spillover effect too
raises big concerns on investors as other sectors like transportation, capital
goods and commercial services are going to be impacted due to repricing of
energy bonds.
A Way Forward
Going by the current trend in Oil price slump and OPEC body
failing to reach agreement in recent meeting in Apr 2016 on temporary freeze
the output level to that of Jan 2016, It is likely that US high yield bond market return will
swing in either direction, from both negative to positive in the low- to
mid-single digits. Along with keeping in mind the fact that U.S federal agency
guidance on further quarter-point hikes[1]
twice before the end of the year 2016, the
momentum for US high yield is most likely to remain challenging. Although, Valuations of high yield bonds are
still attractive in comparison with equities. With all these factors Outlook of
U.S. high yield bond market appears to contain mixed sentiments where investors
are required to be selective and careful in order to identify higher-quality
high yield issuers for investments to be made.
[1]
Source: http://www.forbes.com/sites/samanthasharf/2016/03/16/fed-officials-projecting-two-rate-hikes-in-2016-down-from-four/#6e1748526b02,
accessed on 04/25/2016
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