Download Finding Value in US High Yield Fixed Income

Investment Research
Finding Value in US High Yield
Fixed Income
Jeffrey Clarke, Senior Vice President, Research Analyst, CFA
Thomas M. Dzwil, Director, Portfolio Manager/Analyst
Michael Zaremsky, Director, Client Portfolio Manager
Over the past several years, central banks have tried to repair the damage from the global financial crisis by cutting
interest rates to historic lows. In response, investors have sought income by reaching for higher yield. Many of these
investors, however, may not have fully recognized that higher yields represent higher risk as well as higher returns. As
yields remain under pressure in the face of this demand, the challenge of finding attractive yield that is fairly priced has
intensified. We believe a potential solution is non-distressed US corporate bonds rated BB and B.
In the current market environment, we believe higher quality US high yield fixed income has reached newly attractive
valuations. Falling commodity prices and fears associated with the US Federal Reserve rate hike have brought down
high yield security prices regardless of quality and underlying fundamentals. However, there is a meaningful difference
between the marginal credits that will likely face impairment and the healthy credits that should continue to meet all of
their financial obligations and weather the current market conditions. Therefore, in our view, these depressed prices
could represent an attractive entry point for high yield US corporate bonds with better quality characteristics.
2
High Time for High Yield
One of the main reasons we believe that US high yield bonds
represent value in today’s market is our view that the US economy
will continue to grow, and that interest rate increases will reflect
that strength. The period of ultra-low interest rates since the global
financial crisis has been extraordinary and virtually unprecedented.
The last time interest rates were at current levels for a sustained period
was in the 1930s during the Great Depression. At that time, the US
economy was contracting, deflation had set in, and unemployment
was 19% (Exhibit 1). In contrast, the US economy today—marked by
economic growth, low but steady inflation, and low unemployment—
is no longer in crisis. Interest rates will eventually adjust and rise as
the Fed begins to unwind its crisis-driven policy. We view such policy
normalization as appropriate and necessary given the strength of
current economic conditions.
Rising interest rates are traditionally challenging for fixed income
because of “interest rate risk.” As rates rise, the value of most bonds
declines. The longer the duration of the security, the more value it is
expected to lose. For companies issuing high yield bonds, however,
rising rates can be generally beneficial if they reflect a positive business
environment. Default rates have typically declined in past economic
expansions as companies have been better able to meet their financial
obligations and avoid bankruptcy.1
High yield bonds have outperformed most other fixed income assets
in past rising rate environments (Exhibit 2). The outperformance of
high yield bonds over long-term US Treasuries has been especially
Exhibit 1
The Economy Appears Normal but Interest Rate Policy Does Not
US Treasury 3-Month T-Bill Yields: 1931–Present
significant. This reflects the fact that companies issuing high yield
bonds have greater exposure to economic growth, and that the driver
of high yield returns is not primarily interest rates or duration, but the
underlying strength of the individual issuer. While the asset class is
not entirely immune to interest rate risk, it does have lower sensitivity
to this variable than other fixed income assets (with approximately
half the sensitivity of similar-duration Treasuries). In many cases, the
beneficial effect from spread tightening can more than offset the detrimental impact of an interest rate rise.
Investor sentiment for US high yield fixed income is being supported
by a number of other factors as well. US markets in high yield bond
assets are mature and, unlike in many other countries, bankruptcy
laws and recovery are well established. The US dollar is relatively
strong, and the United States continues to be seen as a safe haven in
global markets. We believe US high yield also has favorable maturity
dynamics, is at an attractive point in the credit cycle, and has a more
stable risk/return profile than is currently priced by the market. US
companies have been able to refinance their debt and issue securities
at longer maturities, which has lowered short-term pressure to pay
their obligations. Prior to the financial crisis in 2008–2009, there was
a “maturity wall” (or a particularly high percentage of debt securities
maturing) between 2012 and 2014. Companies took advantage of the
very low rates available in the wake of the crisis, as well as easy access
to financing, to reissue debt. As a result, the percentage of outstanding
issues due to mature through 2016 and 2017 is significantly smaller
than after 2018 (Exhibit 3).
Exhibit 2
High Yield Bonds Have Outperformed Treasuries and the
Broad Bond Market during Past Rate Increases
Total Return Impact in a Rising Yield Environment, 1994–2015a
(%)
16
US Convertibles
US High Yield
12
EMD Hard Currency
8
EMD Local Currency
4
Asian Bonds
0
1931
1943
Recession
1955
1967
3M T-Bill
1979
1991
2003
2015
US Corporates IG
US Broad Bond Market
US 10-Year Treasury
Cumulative (%)
Annualized (%)
-4
-3
-2
-1
0
1
2
3
1930–1938
Nominal GDP Growth
-16.9
-2.0
Inflation
-18.6
-2.3
Nominal GDP Growth
21.9
3.5
Inflation
10.5
1.7
2008–2014
4
5
(%)
For the period January 1994 to November 2015 (unless otherwise noted)
a Average over rolling 3-month periods with more than 25 bps rise in 10-year Treasury
All data in US dollars. This information is for illustrative purposes only. The performance quoted represents past performance. Past performance is not a reliable
indicator of future results. The indices listed above are unmanaged and have no fees.
It is not possible to invest in an index. Index performance does not represent the performance of any product managed by Lazard. Data shown for periods of rising rates
defined as rolling 3-month periods when the US 10-year yield increased more than 25
bps since 1994, data permitting.
As of 30 September 2015
Broad US Bond Market = Barclays Capital US Aggregate Bond Index; IG Corporate =
Barclays Capital US Investment Grade Credit Index; US 10-year Treasury = Barclays
Capital US Treasury (10-year) Bellwethers Index; EMD (Local) = J.P. Morgan GBI-EM
Broad Composite Index; EMD (USD) = J.P. Morgan EMBI Global Index; Asian Bonds
(USD) = J.P. Morgan Asia Credit Index (data since 1999); US High Yield Bonds =
Barclays Capital US Corporate High Yield Index (data since 2002); Convertible Bonds =
Bank of America Merrill Lynch US Convertibles Index.
Source: Bloomberg, Federal Reserve Bank
Source: Bloomberg, J.P. Morgan Asset Management
Unemployment Rates
1938
September 2015
(%)
19.0
5.1
3
In our opinion, the US high yield market is at an attractive point in its
cycle, which appears to be lengthening (Exhibit 4). Historically, these
cycles have lasted about seven years, and rising acquisition, leveraged
buyout (LBO), and dividend activity (spiking in the 50%–60% range)
often signaled the cycle was near its end. However, six years into
the current cycle such activity remains below the peak levels of prior
credit cycles, and defaults—the cycle tends to be near an end when
they reach elevated levels—are near historic lows. If either of these
indicators had moved materially higher it would warrant caution, but
the data suggest that the current cycle will likely persist longer than
those in recent history.
Finally, the US high yield market is more stable than many perceive.
High yield bonds have historically generated attractive performance
over the long term (Exhibit 5), especially in risk-adjusted terms.
Dispersion has also appeared among rating segments, with higherquality credits providing stronger annualized returns. The BB
Exhibit 3
High Yield’s “Maturity Wall” Has Been Pushed Out to 2018
US High Yield Maturity Profile
Outstanding Issues due to Mature (%)
18
12
6
0
2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025+
As of 30 September 2015
This schedule is based on both bonds and loans maturities.
Source: Bank of America Merrill Lynch
The Impact of Rising Interest Rates on
Income-Generating Assets Can Vary
Exhibit 4
The Current High Yield Cycle Appears to Have Lengthened
Income-generating assets tend to come under pressure
when interest rates rise, but their performance may
depend on other factors as well. When rates were rising
and investors were nervous about growth (e.g., as
occurred in the second quarter of 2013 and September
2014), US high yield fell alongside other assets.
However, when investors were solely concerned about
interest rate risk (e.g., as occurred in the first half of
2015), high yield has tended to perform well, particularly
against other yield proxies. This clearly demonstrates
the benefits of a growing economy for US high yield
credit.
US High Yield Issuer Default Rates and Use of Proceeds
Returns for Income Assets
Source: Bank of America Merrill Lynch, Bloomberg, Moody’s
Default Rate (%)
Use of Proceeds (%)
16
60
12
45
8
30
4
15
0
2001
2003
2005
2007
2009
2011
2013
3Q
2015
0
Defaults, Proportion of Market Value [LHS]
Acquisitions, LBOs, Dividends; Proportion of Total Use of Proceeds [RHS]
As of 30 September 2015
Opinions and estimates are as of October 2015 and are subject to change.
30 January 2015— September 21 May 2013–
10 June 2015 (%) 2014 (%) 24 June 2013 (%)
Change in
10-Year UST Yield
1.64–2.38
2.34–2.49
1.93–2.54
Bank Loans
1.27
-1.86
-1.91
High Yield Bonds
2.01
-2.57
-6.64
EM Local Currency Bonds
-4.62
-4.00
-12.58
Global Consumer Staples
1.50
-1.96
-6.58
REITs
-9.89
-6.92
-15.15
-10.14
-2.53
-7.96
US Utilities
As of 30 September 2015
EM Local Currency Bonds = Market Vectors Emerging Markets Local Currency
Bond ETF; Bank Loans = PowerShares Senior Loan Portfolio; REITs = Vanguard
REIT ETF; Global Consumer Staples = iShares Global Consumer Staples ETF; US
Utilities = Vanguard Utilities ETF; High Yield Bonds = SPDR Barclays High Yield
Bond ETF. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. This information is for illustrative
purposes only and does not represent any product or strategy managed by Lazard.
Source: Bloomberg
Exhibit 5
High Yield Performance Has Been Relatively Strong
January 1989–September 2015
BofA Merrill Lynch US High Yield Cash Pay Index
Annualized
Return (%)
Sharpe
Ratio
8.25
0.60
BB
8.49
0.77
B
7.81
0.53
CCC
7.56
0.31
6.64
0.87
Barclays US Aggregate Index
As of 30 September 2015
This information is for illustrative purposes only. The performance quoted represents
past performance. Past performance is not a reliable indicator of future results. The
indices listed above are unmanaged and have no fees. It is not possible to invest in an
index. Not intended to represent any product or strategy managed by Lazard.
Source: Bank of America Merrill Lynch, Barclays Capital, Bloomberg, Lazard
4
segment of high yield, when compared to the Barclays US Aggregate
Bond Index, has generated 185 basis points (bps) of annualized
outperformance at a similar Sharpe ratio. In addition, higher-quality
US high yield bonds (concentrated in BB and B credits, as represented
by the BofA ML BB–B US Cash Pay Non-Distressed Index) have
historically outperformed the broader US high yield market with
lower volatility (Exhibit 6).
High Yield: Caveat Emptor
High yield bond issuers are a varied group, with a range of prospects.
These differences were apparent to us in the summer and fall of 2015,
when bond market volatility rose as the phase of the economic and
interest rate cycle pressured LBO financing and commodity debt.
This sparked investor concern over the US high yield asset class in
general, with spreads widening for most high yield securities, regardless of their underlying fundamentals. The degree of the movement
appeared unwarranted given that forecasted default rates remain
subdued (Exhibit 7). We believe the negative market sentiment has
driven spreads approximately 200 bps wider than they should be, with
investors under the impression that the recently challenged areas of the
market indicate the poor health of the asset class overall. We view this
disconnect as a potential opportunity for excess return as the market
normalizes and spreads compress.
Exhibit 6
Higher Quality High Yield Bonds Have Historically
Outperformed with Lower Volatility
Performance
(Return %)
Volatility
(Standard
Deviation %)
Risk
Compensation
(Sharpe Ratio)
BofA ML US High Yield
Master Index
0.17
6.08
-0.01
BofA ML BB–B US Cash Pay
Non-Distressed Index
2.10
5.52
0.34
Year-to-Date
In reality, much of the turmoil was limited to only a few sectors—
namely lower-quality high yield issuers (CCC) and companies with
exposure to oil and commodities. This was to be expected given the
downward pressure on prices in those sectors. Thus, US high yield
markets have diverged. The broad spread widening conceals this
divergence between the weaker parts of the market, which are more
likely to default, and the healthy portions of the market, which are less
likely to face any significant impairment. Higher-quality credits have
been resilient and continue to outperform their lower-quality peers.
As credit tightens in the future due to higher rates, we expect to
see greater disparity between winners and losers. We believe this
environment will offer ample opportunities for bottom-up security
selection. Careful research can help identify fundamentally strong
issuers and credits while avoiding those that exhibit imprudent risk.
Exhibit 7
When High Yield Spreads Widened in the Past, Defaults Rose
Spreads and Defaults Have Historically Had Strong Correlations
Option-Adjusted Spreads (bps)
(%)
1,100
16
900
13
700
10
500
7
300
4
100
1998
1
2000
2002
2004
2006
2008
2010
BofA ML US High Yield
Master Index
-2.02
5.73
-0.40
BofA ML BB–B US Cash Pay
Non-Distressed Index
0.43
5.19
0.03
2014
Year-to-Date
Return (%)
US High Yield Master
0.05
BofA ML BB–B US Cash Pay Non-Distressed
1.92
BB
2.29
B
-0.34
CCC and Lower
3-Years (Annualized)
BofA ML US High Yield
Master Index
4.07
BofA ML BB–B US Cash Pay
Non-Distressed Index
4.69
4.94
4.64
0.77
0.95
5-Years (Annualized)
BofA ML US High Yield
Master Index
5.98
5.98
0.95
BofA ML BB–B US Cash Pay
Non-Distressed Index
6.35
5.29
1.14
2016
BofA ML BB–B US Cash Pay Non-Distressed High Yield [LHS]
Moody’s US Speculative Grade Default Rate [RHS]
US Baseline Default Forecast [RHS]
Market
1-Year
2012
-5.92
Distressed
-24.62
Sector
Weight (%)a
Year-to-Date
Return (%)
Energy
12.9
-9.65
Metals and Mining
3.0
-15.87
Paper
1.7
-9.68
Steel
0.6
-7.85
As of 30 September 2015
a Represents sector weights within the US High Yield Master Index
This information is for illustrative purposes only. The performance quoted represents
past performance. Past performance is not a reliable indicator of future results. The
indices listed above are unmanaged and have no fees. It is not possible to invest in an
index. Not intended to represent any product or strategy managed by Lazard.
Forecasted or estimated results do not represent a promise or guarantee of future
results and are subject to change. This information is for illustrative purposes only.
The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The indices listed above are unmanaged and have no
fees. It is not possible to invest in an index. Not intended to represent any product or
strategy managed by Lazard.
Source: Bank of America Merrill Lynch, Lazard
Source: Bloomberg
As of 31 October 2015
5
A Question of Liquidity
Many investors today question whether high yield bond
managers have enough liquidity to cope with extreme
market volatility. They point out that some investment
strategies, such as mutual funds and ETFs, must offer
investors daily or intra-day access to capital while the
underlying assets may be thinly traded or relatively
illiquid. In a well-publicized case in 2015, a high yield
mutual fund was forced to bar further redemptions and
was closed for an orderly distribution. We believe this
does not accurately reflect the underlying conditions in
the BB/B US corporate bond market but instead depicts
it in similar terms as lower-rated credit. The areas of the
market most sensitive to challenging liquidity conditions
tend to be the marginal credits, issuance with small deal
size, or CCC bonds. We believe that higher quality US
corporate bonds will continue to have a reasonable level
of sponsorship.
Conclusion
We believe that US high yield bonds, specifically the higher-quality
elements of the market, are one of the strongest opportunity sets in
the current economic environment. As growth continues, we believe
mid-sized US-oriented borrowers (the companies typically issuing
high yield debt) will benefit via improved revenue growth, potentially
making their bonds more attractive. As a result, we expect that high
yield credit spreads will tighten even as interest rates rise. Past patterns
of high yield performance have shown that higher quality high yield
is resilient in rising rate environments, particularly when growth fears
are absent. In today’s yield-starved world, we believe this can be a
compelling opportunity for investors seeking income with adequate
compensation for risk.
This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management.
Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a
robust exchange of ideas throughout the firm.
Notes
1 High yield default rates rose sharply during the 2001–2002 and 2008–2009 recession and declined or held steady during periods of economic growth (2002–2007 and 2010–2015).
Important Information
Published on 30 December 2015.
Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions expressed herein are as of the published date and are subject to change.
An investment in bonds carries risk. If interest rates rise, bond prices usually decline. The longer a bond’s maturity, the greater the impact a change in interest rates can have on its price. If you do
not hold a bond until maturity, you may experience a gain or loss when you sell. Bonds also carry the risk of default, which is the risk that the issuer is unable to make further income and principal
payments. Other risks, including inflation risk, call risk, and pre-payment risk, also apply. High yield securities (also referred to as “junk bonds”) inherently have a higher degree of market risk,
default risk, and credit risk.
This document reflects the views of Lazard Asset Management LLC or its affiliates (“Lazard”) and sources believed to be reliable as of the publication date. There is no guarantee that any
projection, forecast, or opinion in this material will be realized. Past performance does not guarantee future results. This document is for informational purposes only and does not constitute an
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