Why we believe a market correction in high yield bonds would be a buying opportunity
We are often asked by investors how best to time an investment into high yield. While there is no single answer to this, we can provide some useful perspectives based on a thorough analysis of all of the market corrections occurring so far in this credit cycle.
Today’s market environment
High yield bonds have staged a strong comeback since the 14-week downdraft when oil prices were declining at the end of 2015 and into 2016. From 4 November 2015 through 11 February 2016, global high yield corporate bonds1, were down -8.76% as oil prices plummeted through $30 a barrel amid concerns over growth in China and rising oil supply. However, since 11 February 2016, the high yield market has provided a total return of +28.92% through 31 July 2017. These 17 months have been largely characterised by strong investor risk appetite.
Given this backdrop, and with the US market in the latter stages of the credit cycle, investors may wonder if the opportunity has passed. By mid-summer, on 31 July 2017, the global high yield index provided a yield of 4.71%2 and a spread versus Treasuries of +331 basis points (bps). We believe that a back-up in spreads or yields of 50-100 bps or more would be a buying opportunity. Such cheapening of valuations would likely spur new buying by institutional investors with the global high yield market continuing to exhibit strong underlying fundamentals.
One of the main reasons for our positive outlook on the high yield bond market over the next year is that we do not foresee the credit cycle turning. Given the broad strength of high yield credit fundamentals, any market correction would more likely be triggered by macro, political or geopolitical catalysts than by endogenous high yield market factors. It would also likely be short-lived as investor demand would pick up in response to higher yields.
The default rate increased during the downdraft in commodity prices in 2015 to early 2016, but has improved considerably over the past 12 months. The widely followed Moody’s global speculative grade default rate decreased from 4.8% at the cycle peak in the summer of 2016 (when 80% of defaults were in the commodity-related sectors) to 4.4% by the end of 2016, and to 3.1% by the end of July 2017. This is well below the average rate since 1990 of 4.4%. Moody’s expects that the global default rate will continue to moderate over the next 12 months to only 2.2% by July 2018.
Other important measures of fundamental strength for the high yield universe are also showing clear improvement. The ratio of ratings upgrades to downgrades by the major rating agencies turned positive (i.e., more upgrades than downgrades) in March 2017 and has continued to improve since then. There have also been more rising stars (bonds upgraded from high yield to investment grade) than fallen angels3 (bonds downgraded from investment grade to high yield) in 1H 2017 compared to last year.
The Q2 2017 earnings season has, like the past two quarters, seen high yield issuers deliver healthy growth in both revenues and EBITDA. This is better than the quarterly earnings results for almost every quarter during the prior two years. Key credit metrics such as leverage, interest coverage, and free cash flow as a percentage of debt are stable at solid levels.
Buying during or after a correction
Since the 2008 recession, investors who have bought high yield bonds during or after a market correction have been rewarded with positive returns. The reason is that the technical backdrop tends to improve after a risk-off period as supply typically slows down in response to the correction. Market turbulence also means the pendulum swings in favor of investors in negotiating valuations and other terms on high yield new issues. Higher quality companies are more likely than lower-rated credits to issue bonds following a widening of spreads, often with better structures and better call and bondholder protections.
In addition to better structures, the increased volatility creates investment opportunities to buy bonds in the secondary market at a discount to par value. As exchange-traded funds (ETFs) experience significant outflows, they typically sell large liquid bond issues which can drive prices lower and create relative value opportunities for active managers. As prices fall and yields rise, bond valuations can reset to levels where price appreciation is once again possible.
Characteristics of high yield market corrections in the current credit cycle
|Global high yield index||Average|
|Length of correction||9 weeks|
|Average total return during downdraft||-4.9%|
|Spread change||+162 basis points|
|Starting spread||+522 basis points|
Source: Barclays and Schroders, July 2017. The above is an average of 10 correction episodes between 2010 and 2016.
Investors willing to step in and buy high yield during or just after a market downdraft were well rewarded. In nine out of these 10 episodes, the global high yield index posted a positive return over the subsequent 12 months, with returns in excess of 10% in eight of them, as can be seen in the chart below.
Average Global High Yield (GHY) index* total returns over the subsequent 3, 6, and 12 month periods
Source: Barclays and Bloomberg, July 20174. The above is an average of the same 10 correction episodes between 2010 and 2016.
Market corrections are a natural and periodic occurrence in the high yield market. Since the Global Financial Crisis ended in Q2 2009, there has been at least one material correction in each calendar year. Yet, there has not been a market downdraft so far in 2017. We believe it is possible, but unlikely, that this year will be different. As such, we think investors should prepare to capitalize on the potential opportunity.
When considering whether or not to deploy cash to the high yield market following a correction, an investor should assess if a given correction could morph into a protracted bear market or if the downdraft will prove to be short-term and ultimately met with investor buying at wider valuations. Given the current macro backdrop and solid credit fundamentals, we feel confident that in today’s market environment, any correction will definitely fall into the latter category.
1. Bloomberg Barclays Global High Yield ex-CMBS ex-EMG 2% Issuer Capper Bond Index, USD Hedged↩
2. The 4.71% yield represents the yield-to-worst of the index and the spread of +331 represents the option-adjusted spread (OAS) versus Treasuries of the Bloomberg Barclays Global High Yield ex-CMBS ex-EMG 2% Issuer Capper Bond Index as of month-end 31 July 2017.↩
3. "Rising star" is a credit initially rated high yield (Ba1/BB+ or lower) that is then upgraded to investment grade (Baa3/BBB- or higher) by the major ratings agencies, and “fallen angel” is an investment grade credit that gets downgraded to Ba1/BB+ or lower and falls into the high yield index. Bonds of credits at this cusp between investment grade and high yield can experience substantial changes in spreads and prices due to changes in index membership.↩
4. Data reflect the Barclays Global High Yield ex-CMBS ex-EMG 2% Issuer Capped Bond Index, USD Hedged. Note: “Spread” is the option-adjusted spread (OAS), and “Yield” is the yield-to-worst. Analysis and averages include the 10 high yield market corrections which occurred from the beginning of 2010 through 2016. The dates of the 10 high yield market corrections were as follows: 12 Jan 2010 – 16 Feb 2010, 27 Apr 10 – 11 Jun 2010, 10 Nov 2010 – 30 Nov 2010, 29 Jul 2011 – 4 Oct 2011, 31 Oct 2011 – 24 Nov 2011, 4 May 2012 – 5 Jun 2012, 9 May 2013 – 25 Jun 2013, 29 Aug 2014 – 16 Dec 2014, 29 May 2015 – 29 Sep 2015 and 4 Nov 2015 – 11 Feb 2016.↩
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