Janney’s Investment Strategy Group has maintained a negative disposition for the high yield corporate bond markets for some time now.
The basis of that position was not about large economic or corporate profitability risks, but rather valuations: Spreads, a measure of the incremental income from a riskier bond as compared to a safe one, were very narrow based on historical standards.
In other words, while fundamental measures of risk in high yield bonds were generally low, investors were simply not being paid for taking those risks.
Spreads on high yield bonds widen
Astute readers may notice the past-tense tone of the introductory paragraph. While high yield spreads were narrow heading into 2020, they have widened considerably in February. For owners of high yield bonds, mutual funds,
or exchange-traded funds (ETFs), that has been a painful experience for market values. At the February lows, the high yield index was down more than 2.5% on the year. For prospective buyers of high yield bonds or funds, however, valuations are now
considerably cheaper. Considering the Federal Reserve’s support for liquidity conditions, an economic outlook that is still mainly stable (although risks are growing), and above-average corporate balance sheet health, the high yield sector is
looking at least somewhat attractive.
As of February 28, spreads on high yield bonds rose to 5%, or 500 basis points, above similar maturity Treasuries. That spread represents the widest level since the equity and high yield selloff in December 2018, which proved to be the best buying point for high yield in more than two years. In many respects, the late-2018 market selloff echoes today’s, both in the rapidity with which it emerged and the change in Federal Reserve policy which slowed the selling.
While it is impossible to pick the cheapest entry point—akin to calling a bottom in an equity market selloff—the risk/reward tradeoff becomes far more appealing the wider that spreads move. The reason is a simple one, just as narrow spreads mean investors are not being paid for taking risks by owning high yield, wide spreads mean investors are being paid.
With high yield spreads at 500 basis points, investors in the high yield sector as a whole are essentially “covered” against defaults of the underlying bonds of up to 28% in the next five years, assuming a conservative
recovery on those bonds that do defaults. Even in a downside economic scenario, it seems extraordinarily unlikely that one-quarter of the high yield universe will fail to repay their bonds. Even at its worst in 2009, the one-year high yield default rate
among Moody’s-rated bond issuers only reached 12% (the prior high was 10%), and there is no evidence of 2009-like risks emerging. In fact, the cumulative five-year default rate has only exceeded the 28% cushion currently priced in twice in history.
Fundamental credit quality is also more solid than typical at this point in the cycle.
While much ink has been spilled about the greater amounts of high yield issuance, the weakening financial covenants, and the prominence of alternative financing sources, the reality is that most large high yield issuers actually face at least a moderately positive outlook. Perhaps the best evidence of such an outlook is that liquidity stress, a major indicator of default risk, is well below its long-term average.
Meanwhile, refinancing needs, which tend to peak before defaults, are only about average themselves. Low absolute interest rates meanwhile make it cheaper for high yield issuers to cover their debt service costs.
The high yield corporate markets are a volatile sector, and only appropriate for investors with significant risk tolerance. That said, valuations in the sector have come down significantly, and fundamental health across issuers remains
reasonably positive. While we cannot predict with certainty whether high yield spreads will continue to widen (and the sector under-perform safe bonds), current valuations are, for the first time in more than a year, compelling. Compelling valuations
exist, but other factors should inform the investment decision. But at current spreads, there is a reasonable amount of cushion to protect investors against an increase in defaults.
I, Guy LeBas, the Primarily Responsible Analyst for this report, hereby certify that all of the views expressed in this report accurately reflect my personal views about any and all of the subject sectors, industries, securities, and issuers. No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.
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