Fixed-Income Insights: When High Yield Loses Some Height
By Zane Brown
February 12, 2013
If one sought an indication of how monetary policy and historically low interest rates can influence investor behavior, the high-yield bond market could provide some perspective. In 2012, investors' ongoing demand for income was reflected by the high-yield market's 15.6% return, the $32 billion that flowed into the asset class, andâ€”as several headlines pronouncedâ€”the market's record-low yields of less than 6%.1
Managing Market Risk
While it remains to be seen what the market may deliver by the end of 2013, its current state deserves some context. After all, historically low interest rates have led to record-low yields in a number of fixed-income bond markets, and inflation still remains subdued. With that backdrop, an appropriate consideration for investors may be whether a high-yield strategy can adequately compensate them for the credit risk they may be assuming. And an important aspect of managing this risk in the current environment relates to diversification.
An investment strategy could pursue a diversified portfolio in an attempt to avoid significant losses on a specific position. This level of diversification is available in many high-yield strategies, such as those that closely replicate benchmark indexes and exchange-traded funds (ETFs). Yet, diversification does not guarantee a profit or protect against a loss in declining markets, and if the mandates of these strategies require similar portfolio holdings, they may not be diversified fromÂ each other. Given these similarities and the recent popularity of the asset class, a shift in the market or a certain credit could be problematic in the event that these strategies react in a very un-diversified way.
For example, two large high-yield ETFs, which combined manage nearly $30 billion, track indexes consisting of U.S. dollar-denominated, high-yield corporate bonds. As a result, their holdingsâ€”and those of other strategies that replicate an indexâ€”can be very similar. This explains why (as of late January 2013) they held combined positions of more than 8% in a $3 billion issue from Sprint Nextel, which is among the largest issues in the benchmark indexes.2
While an active strategy might also hold the Sprint Nextel issue, it could have far less exposure to the credit than either of the ETFs. This flexibility also allows the active strategy to seek attractive yields beyond the U.S. high-yield market, which can provide a greater level of diversification away from those strategies that only mimic a benchmark index.
For instance, an actively managed strategy could complement its holdings of high-yield corporate bonds with allocations of commercial mortgage-backed securities, international bonds, non-dollar-denominated debt, leveraged loans, preferred stock, and convertible bonds. In some cases, these allocations could be up to 20% of the portfolio and could contribute to portfolio yields that differ from the high-yield benchmark indexes.
In addition to the role diversification can play in risk management, investors also might consider how the decline in speculative-grade3Â yields has lowered companies' cost of capital, improved the flexibility of their capital structure, and otherwise strengthened corporate credit quality. Indeed, the availability of low-cost capital has allowed corporate borrowers to refinance upcoming maturities and to reduce, by 71%, the amount of debt due in 2014. And because only $184 billion in debt is scheduled to mature by the end of next year, this greatly reduces the potential for a surge in defaults as a result of companies not being able to refinance their debt. For context, new issuance in the market reached a record of more than $368 billion in 2012.
Historical and Relative Value Perspectives
The improvement in credit quality over the past few years may contribute to an estimated default rate on high-yield bonds of less than 2% through 2014, well below the long-term average of 4.2%. (See Chart 1 for additional default data). The stronger fundamentals also may mean that if the economy unexpectedly stumbles into a recession in 2013, the default rate could increase to an estimated range of 5â€“6%, rather than the range of 10â€“15% that occurred during prior recessionary periods.4
In addition to factors affecting credit risk, investors should consider the return potential of high-yield strategies. The momentum behind the asset class has tightened credit spreads to 517 basis points (bps) over Treasuries (as of late January 2013), which is 74 bps less than the long-term average. Yet, credit spreads historically have tightened to less than 400 bps over the course of a full credit cycle, the last three of which lasted six to eight years, although there is no guarantee the high-yield market will perform in a similar manner in the future. Based on that prior experience, however, and assuming the prior cycle started in 2009, the current cycle could end in 2015, with the potential to extend to 2017.
Another relative value indicator also points to the potential for further compression or stability in speculative-grade yields when compared to Treasury yields. Over the past 20 years, for instance, high-yield securities have offered an average premium of about 150% of the yield on the 10-year Treasury note. With the 10-year note yielding about 1.96%, this historical relationship suggests that high-yield securities should yield 4.9%, which is less than the current level of about 5.75% (as of late January 2013).
While this relationship indicates that speculative-grade yields could compress further, it is important to consider another scenario that investors may be concerned about. Indeed, stronger economic growth or signs that the Federal Reserve may be limiting its quantitative easing could lead to an increase in the 10-year Treasury yield. But even if the 10-year yield rose as high as 3.83%â€”an extreme short-term move from its recent levelsâ€”speculative-grade yields could remain at 5.75% and still maintain their historical premium of 150% over the 10-year Treasury yield.
This relative-value comparison provides some perspective on the current state of the high-yield market in an environment where yields in a number of fixed-income markets are at, or are near, record-low levels. In addition, the effect of solid credit fundamentals and the flexibility of actively managed strategies to identify attractive yields and improve portfolio diversification mean that investors shouldn't be alarmed by record-low yields and could find additional high-yield opportunities in 2013.
1Â All market data in the document are from J.P. Morgan, unless otherwise noted.
2Â Exchange traded fund data are from State Street Global Advisors and BlackRock iShares.
3Â Speculative grade refers to high-yield securities in this usage.
4Â Default data are from J.P. Morgan Credit Strategy Weekly Update, January 25, 2013.
A Note about Risk:Â Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Fixed-income securities may also be subject to call, credit, liquidity, and general market risks. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Moreover, the specific collateral used to secure a loan may decline in value or become illiquid, which would adversely affect the loan's value. Investing in international securities generally poses greater risk than investing in domestic securities, including greater price fluctuations and higher transaction costs. Special risks are inherent to international investing, including those related to currency fluctuations and foreign, political, and economic events. Convertible securities have both equity and fixed-income risk characteristics. Like all fixed-income securities, the value of convertible securities is susceptible to the risk of market losses attributable to changes in interest rates. Generally, the market value of convertible securities tends to decline as interest rates increase and, conversely, to increase as interest rates decline.
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