July 2019

High Yield: Pushing Boundaries

Corporate Credit

The dovish tilt to global monetary policy should be supportive of asset prices in the near term but Portfolio Managers Tom Ross and Seth Meyer observe that an extension of the credit cycle does not mean abandoning selectivity within high-yield bonds.

Key Takeaways

  • Fresh central bank policy accommodation is supportive, but investors should not lose sight of the fact that policy easing is only happening because of economic weakness.
  • The shift in policy could catalyze spread tightening, in which case European high yield offers a potentially more attractive starting point and technical backdrop.
  • Idiosyncratic risk leads to high dispersion of returns in high yield, so even in an extended cycle, it is worth retaining “quality control.”

In 1968, in the Men’s 100 meter sprint, Jim Hines of the U.S. hit a world record of 9.95 seconds, which would stand for 15 years until Calvin Smith shaved 0.02 seconds off it in 1983. In 2009, Usain Bolt of Jamaica would cut 0.11 seconds off his own world record set a year before and bring the record to its current level of 9.58 seconds.

On the Threshold of a Record

Sometimes records seem insurmountable, other times they are almost meaningless. The U.S. economy stands at the threshold of a new record – if it grows through July, it will break the record for the longest unbroken expansion (120 months between March 1991 and March 2001).

Records matter in that they can create a psychological limit, but just because something held true in the past does not mean it will do so in the future, particularly if circumstances change. So is the current economic expansion the equivalent of Usain Bolt – one that will power substantially past the previous record – or is it a Calvin Smith moment of limited advance?

Exhibit 1: Need for Yield Drives Inflows into U.S. and European High Yield

Source: European flows – JPMorgan, Bloomberg, includes ETFs; U.S. flows – Barclays, Lipper, includes ETFs, as of 5/30/19

The question is not an unreasonable one for high-yield bond investors to ask. As lenders to companies, we need to be confident that the economic environment a borrowing company is facing is favorable so that we will collect the bond repayments. Although corporate fundamentals drive the majority of performance in high-yield bonds, we recognize that it has become increasingly important to consider macroeconomic factors.

The Grab for Yield Continues

The dovish shift by central banks is accentuating the grab for yield as expectations of further rate cuts intensify. Within the Bloomberg Barclays Global Aggregate Index¹, the percentage of negative-yielding assets reached a record high in June 2019, while the yield on the German 10-year Bund fell to a record low of -0.3%. Contrast that with an average yield of 5.9% for the ICE BofAML Global High Yield Bond Index in late June 2019. It is small wonder, therefore, that investors are moving into high yield as a source of income, which is evident from the fund flows data shown in Exhibit 1.

U.S. Rates Effect

Yet despite the broadly supportive technical backdrop of reasonable demand and subdued issuance (year-to-date net issuance in Europe remains below the levels seen over the same period in 2018, although U.S. high-yield gross and net issuance is higher), there has been a reluctance on the part of investors to drive credit spreads aggressively tighter. Exhibit 2 highlights how the decline in yields on global high-yield bonds has been heavily influenced by a rates effect (the decline in equivalent government bond yields). The yield has declined from 7.5% (750 basis points) in December 2018 to 5.9% in June 2019, yet spread narrowing accounts for only 100 basis points of the 160 basis points fall.

In fact, if we take the difference between the yield and credit spread as a proxy for the rates effect, we can see that rates have been helping to offset spread-widening episodes in Q4 2018 and May 2019.

These spread-widening episodes bring us back to our opening analogy on how long the economic expansion can continue as they each correspond to growth scares: Q4 2018 reflecting concern that the U.S. Federal Reserve (Fed) was making a policy error by overtightening; and May 2019 reflecting fears that trade war escalation would push a weakening global economy over the edge.

Exhibit 2: Yield and Spread of Global High-Yield Bonds

Source: Bloomberg, ICE BofAML Global High Yield Bond Index. Index tracks the performance of USD-, CAD-, GBP- and EUR-denominated below-investment-grade corporate debt publicly issued in the major domestic or eurobond markets, 6/18/18 to 6/18/19. 100 basis points = 1%.

Policy Easing Returns

The U-turn by central banks toward additional policy easing needs context. It is only taking place because economic data has weakened. The Trump tax stimulus is fading, business confidence and purchasing manager indices globally are declining, and manufacturing, particularly autos, is feeling the combined impact of a slowdown in China and industry disruption. To be fair, employment levels and wage growth have been robust, but these tend to roll over later in response to prolonged weakness at the corporate level.

What is astonishing is that the Fed has altered course over the summer without significant market weakness. This may tell us one of two things. Either it is genuinely concerned that the economic weakness is structural and that the U.S./global economic expansion has reached its limit, or it is acting pre-emptively in the belief that this is simply a mid-cycle slowdown and early action can extend the cycle.

In pledging “to act as appropriate to sustain the expansion,” the Fed is joined by the European Central Bank (ECB) in promoting further policy easing and central banks as far afield as Australia cutting rates. There is also increasing support for fiscal expansion, framed by politicians with an eye on growing populism. Taken together, accommodative monetary policy and greater government spending should extend the credit cycle.

Exhibit 3: Gross Leverage Levels in High Yield

Source: European gross leverage – Morgan Stanley Research, Bloomberg, using a sample from the European iBoxx HY index, as of 12/31/18. Index reflects the performance of EUR-denominated sub-investment-grade corporate debt. U.S. gross leverage – Credit Suisse, Credit Suisse Liquid U.S. High-Yield Index, as of 12/31/18. Index tracks the liquid, tradeable, U.S. dollar-denominated high-yield debt market.

Interest Coverage High, Leverage Levels Fair

Against this backdrop, global high-yield fundamentals are reasonable in both the U.S. and Europe. Interest coverage remains high relative to history, despite some deterioration in the U.S. We expect leverage to head higher in 2019 as earnings soften and the deleveraging that has been taking place within the energy sector since its crisis in 2015 begins to fade. However, leverage levels do not look excessive, as shown in Exhibit 3, and with the backdrop of easier policy should create the conditions for spread tightening.

In such circumstances, we see better value in European high yield compared with U.S. high yield. This is because at a ratings-adjusted level, the European market offers more attractive spreads in absolute terms and in terms of the gap between current levels and recent tights (lows), as shown in Exhibit 4. The risk of a rate rise from the ECB is also smaller and the likelihood of corporate bond purchases greater – both of which should help drive spreads tighter.

Exhibit 4: Europe and U.S. High-Yield Single-B Rated Credit Spreads

Source: Bloomberg, 6/19/15 to 6/19/19. LIBOR option-adjusted spread. Europe: ICE BofAML Single-B European Currency High-Yield Index. Index tracks the performance of EUR- and GBP-denominated below-investment-grade corporate debt rated B1 through B3 (inclusive) publicly issued in the eurobond, sterling domestic or euro domestic markets. U.S.: ICE BofAML Single-B US High-Yield Index. Index tracks the performance of U.S. dollar-denominated below-investment-grade corporate debt rated B1 through B3 (inclusive) publicly issued in the U.S. domestic market.

Quality Control Required

Yet, the longer the cycle extends, the more likely that bondholder-unfriendly late-cycle behavior builds. While the high-yield sector has actually been better behaved than the investment-grade sector this year in terms of a higher proportion of primary use of proceeds going toward debt refinancing and repayments (75% of U.S. high yield compared with just 30% of U.S. investment grade²), the prospect of looser policy could undo this. Meanwhile, the buildup of leverage in investment grade risks a flood of downgrades into high yield. Looking at the European high-yield bond market to mid-May, Exhibit 5 identifies a marked dispersion in returns.

This was, in aggregate, a period of positive returns for high yield. A move from risk-on to a risk-off environment could easily see similarly wide dispersion but with a negative return bias. We believe that global high yield will attract investors in coming months, but geopolitical concerns, rising corporate costs, fragility in economic data and the effects of disruptive competition on individual credits means it is worth building some defense into a portfolio. In our view, this means engaging in “quality control,” not necessarily in terms of higher credit ratings but in identifying issuers where directional improvement in cash flows and balance sheets is evident.

Exhibit 5: Dispersion of Returns within European High Yield

Source: Credit Suisse, Credit Suisse Liquid European High Yield Index, year-to-date (YTD) returns to 6/15/19. Index tracks the liquid, tradable, investible universe of the European high-yield debt market, with issues denominated in U.S. dollar, euro and sterling. Past performance is not a guide to future performance.

1 Bloomberg Barclays Global Aggregate Bond Index is a broad-based measure of the global investment-grade fixed-rate debt markets.
2 Source: Dealogic, Goldman Sachs, year-to-date use of proceeds, as of 6/18/19

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