Be it the nearly 5% decline in corporate profits year over year that we saw in the third quarter or the flat retail sales over the past three months domestically, or the GDP slowing and declines we are seeing worldwide, it is clear we are in a slow growth environment. While this is clearly a negative for equity markets, we don’t need growth for value to be had in the high yield debt market. Unlike equities where investors need earnings increases to drive equity prices up, we just need currently manageable capital structures to remain that way and companies to continue paying their bills. In fixed income we have built in call and maturity dates providing us an end game, barring a default/restructuring. This means that over time, the price of the bond generally moves toward the call or maturity price as those dates approach, all the while providing income as you muddle through the price noise along the way.
As we look at the high yield market, we view spreads as a primary way to assess the value proposition. High yield spreads are near levels not seen for the past three years.1
Current spreads of 682bps offered for investors are 25% above historical median spread levels for the high yield market, as well as massively above the levels we saw mid-cycle (2004-2006) during the last economic cycle. It is also important to note that high yield bond relative to investment grade bond spreads are also offering what we see as compelling value versus historical levels.2
With the spread widening that we have seen so far this year, we are posting negative returns year-to-date for the high yield market, which is a rare occurrence. Historically there have only been five years of negative returns going back nearly thirty years.3
Furthermore, it is worth keeping in mind the performance of the high yield market following these periods of negative returns.4
We have not only seen strong, double digit returns on average in the year following a negative return for the high yield market, but the strong returns persisted for the three years following the negative return year. And the average returns in the years following negative return years far outweighed the negative years. Also of note, high yield performed better than equities after the negative years.
We believe the recent decline for the high yield space is now offering compelling future return prospects for investors. Not only are we seeing the best value that we have seen in the high yield market over the past few years, but it is important to point out that this is in the face of well below average default rates and continued below average default expectations (see our commentary “The Defaults Ahead”), bond maturities pushed out for several years, and improving cash flow coverage relative to interest expense (meaning more room for potential cash generation at the corporate level). While we believe fundamentals are reasonable and capital structures manageable for much of the high yield market, there are certainly companies to avoid, specifically in the energy space—an area where we do expect default rates to meaningfully tick up and an industry that is a large portion of the high yield indexes—posing potential challenges for passive products that have to track the entire market. Because of this we believe credit selection is key. There will be pockets of weakness and selective problem industries, but we don’t expect that we are on the verge of the credit cycle going bust; thus, we see the current environment as a terrific opportunity for active investors in the high yield debt markets. For more on our thoughts about the value in today’s high yield market, see our piece “Making Sense of Markets.”
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