High-yield corporate bonds have had a stunning bull run since 2009. By way of illustration the running yield (yield to maturity) of the BofA/Merrill Lynch US High Yield Index was 13.38% on June 30th 2009. On June 30 this year the running yield was 5.74%. In Europe the story is the same – the running yield (yield to maturity) of the BofA/Merrill Lynch Euro High Yield Index was 17.50% on June 30 2009. On June 30 this year it was 4.20%. According to data from this index provider (which goes back as far as 1997), yields have never been so low (Figure 1 below illustrates the fall in the absolute yields of eurozone high-yield bonds).
Figure 1: The absolute level of eurozone high-yield bond yields has reached all-time lows this year.
Source: Barclays Capital, Bloomberg, BNPP IP
The historically low yields we are now seeing beg the question of whether high-yield remains an attractive asset class. We asked credit specialists Boriana Borissova and Pankaj Shah from the Multi Asset Solutions* team to present the bull and the bear case.
To even up any philosophical biases, we asked Boriana, who tends to see the glass as half full, to present the bear case, while Pankaj, for whom the same glass tends to be half empty, argues for the bulls.THE BEAR CASE Boriana's bearish view is based on the following four arguments: 1. Valuation 2. Liquidity 3. Fed tapering 4. Leverage
Regarding valuation, spreads are trading at multi-year lows and yields are at record lows, so high-yield offers very little upside potential at this point.
Liquidity is traditionally an issue in the high-yield bond market, especially in turbulent times. High-yield has the same reputation as the Hotel California: you can check out any time you like, but you can never leave. Divesting smoothly was clearly an issue during the financial crisis, but the market’s capacity to cope with investors cutting positions may have worsened since. Regulatory changes are one of the reasons why banks have become less willing to trade in high-yield bonds. Primary dealer’s holdings of corporate debt instruments fell steeply during the financial crisis and have never recovered. High-yield is also an asset class where gross issuance of new bonds is high relative to secondary market turnover (i.e. the entrance would appear to be bigger than the exit).
According to Boriana, the third reason to be bearish is Fed tapering. The US Federal Reserve has been slowing its asset purchases by USD 10 billion a month. At this time, nothing suggests that any change in the rhythm of these purchases is imminent. This means the quantitative easing programme is due to end in December at the latest, but possibly as early as October. After last year's false start, this year's tapering has been uneventful: bond yields have stayed low and equity markets in the US are at record highs. We think the Fed’s largesse has been instrumental in suppressing market volatility, but this may change towards the end of the tapering process.
Finally, leverage may be interpreted as a red flag by credit investors. The face value of outstanding global high-yield bonds has surged in recent years as corporates have taken full advantage of the attractive terms for funding. A sharp increase in global M&A activity may be beneficial for equity holders, it is usually less favourable for bond holders.
Boriana closed her presentation with the following quote from comments made by Federal Reserve Chairwoman Janet Yellen on 18 June 2014:
”I’ve spoken in recent congressional testimonies and speeches about some threats to financial stability that are on our radar screen that we are monitoring, trends in leverage lending and the underwriting standards there, diminished risk spreads in lower-grade corporate bonds. High-yield bonds have certainly caught our attention. There is some evidence of reach for yield behaviour.“
This warning follows on the heels of remarks by Federal Reserve Bank Governor Jeremy Stein, who on 6 May said that:
“Crucially, in asset markets, it is often the beliefs of the most optimistic investors — rather than those of the moderates — that drive prices, as they are the ones most willing to take large positions based on their beliefs. Moreover, this same optimism can motivate them to leverage their positions aggressively.”
Governor Stein had previously warned on several occasions about froth in the corporate bond market.THE BULL CASE
Pankaj started his counter-arguments by pointing out that Chairwoman Yellen’s warning may be premature – being right is one thing, what matters is timing. Pankaj went on to present no less than six arguments in favour of high-yield bonds:1. Corporate fundamentals/leverage 2. Monetary easing by the BoJ and likely the ECB 3. The macroeonomic environment 4. Hunger for yield 5. Valuation 6. Liquidity
Pankaj’ first point was that corporate fundamentals are generally sound. Corporate debt loads may be rising, but this is more a phenomenon in the US than in Europe. Interestingly, risk premiums of US high-yield bonds have kept falling, even though net debt-to-earnings before interest, tax, depreciation and amortisation has worsened. And assets are rising. In fact, leverage as a percentage of total assets has been falling in Europe in the past few years. The level of cash on corporate balance sheets is relatively high. Also positive in this respect is that default rates are low and have trended even lower lately.
The second argument is that monetary policy is far from restrictive. ECB president Mario Draghi was as clear as any central banker can be in his news conference last month about being ready for further action (“Are we finished? The answer is no”). Having cut rates in June, introduced a negative deposit rate, and announcing a range of other reflationary measures the ECB stands ready to do more. As for the Bank of Japan, the main discussion is not about ‘if’ quantitative easing will be increased, but ‘when’.
Also in favour of high-yield is the improving macroeconomic environment. Europe’s economy is now in recovery, while the US is heading for a strong second quarter. Growth in Europe will not be strong, but modest growth tends to support high-yield.
High-yield corporate bonds should benefit from the hunger for yield. In the current low-yield environment, money has steadily flowed to corporate bonds. On a risk-adjusted excess return basis, European high-yield has outperformed all other broad asset classes in the past 12 months. In other words, European high yield has had the highest Sharpe ratio. US high-yield ranked sixth out of 26 asset classes we looked at.
Steady inflows have led to lower spreads and yields, but with spreads still higher than before the financial crisis, valuations could rise further. The trend may be your friend.
That brings us to the last argument in favour of the bull case: liquidity. Of course, this will be an issue when markets turn, but why look for the door when no exit is needed? There are no signs that the inflows into the asset class are set to reverse.
True to her more optimistic view on European high-yield, Boriana emphasised after the presentations that the negative leverage factor applies more to US than to European high-yield where we hold our overweight. As for valuations, we think they are a negative factor for credit, but more so for investment-grade than for high-yield. Overall, with generally strong corporate fundamentals, earnings that in our view should improve, an improving economic environment, central banks keen on keeping interest rates and bond yields low, and continuing inflows into the asset class, we have stuck to our overweight position in European high-yield.
However, we hold this position more to benefit from the carry than from further price gains. We also think the investment horizon has shortened from the initial 12 months.
We originally wrote this post on 16 May 2014 and was subsequently updated on 1 July 2014 (after a further rally in the high-yield debt market).