By Spencer Hogeweg – Porfolio Manger Credits, Aegon AM
High yield investors had a good start of the year with returns exceeding 6% in Europe and 8% in the US (in dollar terms). That raises the question: where do we go from here? Obviously, the high yield market is not a very liquid market and entry fees are substantial. But is there any need to sell already? Or should we continue to profit from this clear-cut and exploitable market anomaly?
The latest edition of the Deutsche Bank AG’s default study suggests that credit spreads are still relatively wide. The following chart shows the annual default rate on high-yield bonds rated single-B by Moody’s Investors Service. What stands out is the reduction in the default rates since the dot-com bubble, which coincides with the decisions that the central banks in the developed markets made to slash interest rates and keep them at historically low levels. Low interest rates make it easier to meet debt payments and facilitate refinancing of debt, allowing corporates more time for a turnaround.
Graph 1: Annual default rates for B-rated HY bonds. Source: Moody’s, Deutsche Bank
Negligible default chance for BB’s
Due to the lower level of the underlying interest rates, a single-B rated credit is far less likely to default these days than in the 80s or 90s. BB rated credits confirm the findings of single-Bs. Since the financial crisis, the number of BB defaults has been zero in four out of nine years, and the BB default rate has only once risen above 0.3%. In the previous 29 years we saw three years with no BB defaults, and the annual rate was more than 0.3% in 22 of those years. CCCs, however, are the exception as there has been no obvious step-down in defaults after 2004.
Yet, as we look at the market, average spreads have been identical in both the pre and the post 2004 periods, which means investors are now better rewarded for default risk, especially if you believe this low-default environment continues. There is also some evidence European defaults have been structurally lower than US defaults over the past 15 years.
Graph 2: Spread for B-rated HY bonds. Source: S&P, Deutsche Bank, FactSet
Have companies levered up since the financial crisis? A look at long-term credit fundamentals shows that corporates are not really levering up in high yield. Obviously, the size of the BBB market and potential downgrades that would follow should we enter a recession, is a concern. So is the issuance of covenant-lite loans in the leveraged loans market, although that doesn’t necessarily bring large scale defaults in the next cycle as without covenants there are fewer triggers that lead to defaults.
Market liquidity still a concern
The caveat is that the market is no longer as resilient to shocks as it once was, because there are fewer dealers holding much less inventory. Also the dealers are managing their own books like portfolio managers and don’t want to take the other side of the trade anymore, should the market turn.
This is what we clearly saw in the last quarter of 2018. Liquidity dried up very rapidly as traders and portfolio managers attempted to reduce risk and risk appetite completely disappeared in November and December. But it took less than a week in the new year for the market to return to “risk-on”, which resulted in such good returns that the losses of 2018 were fully erased.
The Deutsche Bank research report characterizes the world as high-debt, low-growth, low-real yield, low-default, low-liquidity. That is a very challenging combination for investors. But that same combination should be great for buy-and-hold high yield investors, which could exploit the excess returns in credit relative to long-term default averages. As the European high yield spreads are wider than US spreads, one could argue that buy-and-hold European high yield investors have a lot of default protection embedded in spreads.
Overweight high yield bonds
In our asset allocation we hold a tactical overweight in high yield bonds versus an underweight in sovereign bonds. In the current environment of low interest rates, we expect investors to continue their search for yield and add to credit positions. Even though spreads have tightened considerably in the last few months, we still think that high yield bonds continue to outperform government bonds taking into account the excess yield of about 350 basis points.