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When coupons are king: the case for global high-yield credit

With markets in freefall, high-yield bonds have been particularly affected and credit spreads recently rose above 1,000bps for the first time since the 2008 financial crisis. But in risk lies opportunity and the market rout means that high yield is trading at attractive valuations. At a time when listed companies are cutting dividends, we believe that high yield’s income-generating qualities means that it has the potential to deliver superior risk-adjusted returns earlier on in the market’s recovery.

Listen to Andrey Kuznetsov, Senior Portfolio Manager, talk about why he thinks high-yield credit is an attractive asset class in this short clip.

 

Pandemic panic: a rapid shakeout

With markets roiled by the coronavirus pandemic and the failure of the Organisation of Petroleum Exporting Countries (OPEC) and Russia to reach a supply-cut agreement, the high-yield market has sold off at an unprecedented pace in recent weeks. Historically, it has taken longer for credit spreads to adjust to market turmoil. However, the extent of the market shock means that the widening has been faster than during any other market drawdown over the past 18 years (see figure 1).

Figure 1. Credit spreads unwind at a record pace

Source: ICE Bond indices, as at March 2020.

In this late-cycle environment, pressure was building as it became increasingly clear that coronavirus outbreak was becoming a global crisis. OPEC’s failure to support markets at the end of February was the final straw. Markets reacted violently, causing volatility to rise to its highest level on record.1

There has been a coordinated response from central banks, with both the Federal Reserve (Fed) and the European Central Bank (ECB) indicating a “no limits”2 approach to shoring up the global economy. The ECB launched a €750bn bond-buying programme that covers both sovereign and corporate debt, while the Fed cut interest rates to almost zero and authorised additional purchases of government debt, mortgage-backed securities and (importantly) short-term investment-grade bonds.

While these moves are unprecedented in scope, with interest rates at record lows monetary-policy makers may have run out of ammunition. Credit spreads have tightened in response, but fixed-income markets are still by and large in shock after financial conditions have tightened and access to capital markets has become more challenging.

Nonetheless, we believe that the recent policy moves will provide substantial support and help improve funding conditions for all companies. While high-yield bonds have been excluded from central-bank purchase programmes so far, the re-opening of the primary market for investment-grade issuers is encouraging and will help more high-yield issuers raise debt in the coming months.

High yield: in the eye of the storm

High-yield credit is particularly vulnerable to stressed market conditions. As the economy starts to suffer, opportunities to secure funding become more limited and companies may be less able to pay off their debts. High-yield bonds have taken a beating this year and markets have priced in a 30%-40% chance that they will not be able to raise capital at the unsecured level (defined as when spreads breach 1,000bps).

Figure 2. Spreads signal a pickup in defaults over the next 12 months

Source: ICE Bond Indices, as at March 2020.

While companies are doing what they can – cutting dividends, buybacks and capital expenditure, and finding ways to optimise their cost structures – it seems likely that defaults will rise over the next year. This is undoubtedly a challenging time for issuers and earnings will take a hit.

Ratings agencies have also been quick to respond, and the pace of downgrades has risen substantially. This means that fallen angels – or issuers downgraded to high-yield status – with about $100bn-worth of debt have entered the market over the last month, a trend that is only likely to increase.

The silver lining is that credit quality within the global high-yield market is currently much higher than during previous drawdowns. The number of fallen angels, coupled with the fact that more leveraged financing has taken place in the loans market, means that the average credit rating of the high-yield market has improved and now stands at BB. The BB-rated share of the market is at an all-time high of 58%, while the CCC-rated segment is currently 8% – a record low (see figure 3).

Figure 3. The composition of the high-yield market is changing

Source: ICE Bond Indices, as at March 2020.

Virus valuations: looking cheap

All this means that high yield is currently trading at its most attractive valuations in years. The cash price of high yield recently fell below 80, a level not seen since the financial crisis. Because of this, convexity concerns have been all but banished. Yields and spreads also offer the chance to gain attractive levels of income.

High-yield credit spreads above 1,000bps is a level that has historically proved to be a good entry point for asset allocators with a medium-term investment horizon. Since the late 1990s, there have only been about 57 weeks when spreads were above this level. In only three of these did investors lose money over the following year, and for the rest the average return was almost 40% (see figure 4).

Figure 4. Can higher spreads lead to outsized returns?

Source: ICE Bond Indices, as at March 2020.

There are still many unknowns, and history does not always repeat itself. Nonetheless, a historical viewpoint suggests that there is considerable potential to secure some upside going forward – and that this could be an attractive entry point into high yield. While timing the bottom of the market is hard, it is clear that high-yield credit has demonstrated resilience over time and tends to bounce back strongly after sell offs.

Seeking income: high yield or equities?

Amid the surge of central-bank stimulus, investors have started to think about how to take advantage of attractive valuations as they continue to manage the effects of the crisis. With investors hungry for income, equities and high-yield bonds are natural considerations.

Not only has global high-yield credit delivered better risk-adjusted returns then equities over the past 15 years, it has also recorded lower drawdowns (see figure 4). This is in part because high-yield credit sits above equities within the capital structures of companies, and so takes priority during bankruptcies (and therefore provides a greater degree of protection). But high yield also offers the opportunity to capture the upside. Over the past 15 years, it has delivered almost 60% of the upside of equities with only 40% of the downside.3

Figure 5. The performance of global high yield and equities over the last 15 years

 

Maximum drawdown

Sharpe ratio

ICE BofA Global High Yield

-34.17

0.61

MSCI World  

-54.03

0.44

Source: Morningstar, as at March 2020. ICE BofA Global HY TR USD and MSCI World NR USD. 1 April 2005 to 31 March 2020.

The income-generating qualities of high yield – or the fact it pays investors coupons – helps explain why it has been able to generate relatively attractive risk-adjusted returns. Figure 5 shows how high yield has regained lost ground more quickly than equities after both the 2001-2 and 2008 market crashes.

Figure 6. High yield has recovered more quickly than equities

Source: ICE Bond Indices, as at March 2020. The US high-yield market currently accounts for more than half of the global market, so is seen as a good proxy measure.

This resilience is partly due to the fact that the coupons of high-yield bonds tend to deliver income much sooner in the cycle than equities do. Companies that issue bonds are legally obliged to pay out coupons in all market conditions, while dividends are dependent on performance and are delivered after all interest has been paid.

In other words, high yield has the potential to deliver more upside during the recovery periods following market drawdowns. This is also shown by the ‘recovery efficiency’ of high-yield bonds compared to equities, which is measured by looking at the drawdown period as a proportion of the recovery period. During the drawdowns of the past 30 years, the average recovery efficiency of US high-yield bonds has been higher than for equities (see figure 6).

Figure 7. Recovery efficiency of US high-yield bonds and equities

 

Barclays US Corporate High Yield Index

S&P 500 Index

July 1990 – October 1990

75%

167%

February 2001 – July 2002

243%

100%

May 2007 – November 2008

225%

43%

Average

181%

90%

Source: Bloomberg, Federated Hermes, as at March 2020. Monthly data from August 1988 until March 2020. Recovery efficiency is the drawdown period divided by the recovery period.

High equity returns in recent years have been boosted by share buybacks, something that is unlikely to continue in the current environment. And if sectors are subject to state bailouts, they may be forced to suspend dividends. By contrast, central-bank support will help ensure that companies are able to pay coupons on time.

Our approach to investing in high-yield credit

The last decade has seen the considerable growth of passive fixed-income investing – at the peak, the value of global exchange-traded bonds funds exceeded $1trn – and there is an increasing bifurcation between high- and low-active share investing.

At the international business of Federated Hermes, we are active, high-conviction credit investors and believe that in the current environment, a flexible approach to high-yield credit is more important than ever. Although policy support should reduce the number of defaults, there will still be many companies that do not recover. Active strategies will be better placed to assess which credits have the potential to withstand the turmoil.

As part of our investment process, we determine our risk appetite using duration-times spread, before strategically allocating across different regions, ratings, parts of the curve, sectors, instruments and currencies. High-conviction, bottom-up security selection identifies attractive credits, while an emphasis on liquid, quality names lets us reallocate to take advantage of opportunities – such as those which are evident today.

Global high-yield credit: a diverse ecosystem

The high-yield universe has globalised rapidly over the last 20 years (see figure 7) and we believe that allocating capital to regions other than the US can help optimise a portfolio’s risk-return profile. There are now 85 countries in the high-yield market, compared to 22 two decades ago. Although the market crash is a global one, countries recover at different speeds and we believe our global outlook should help us diversify in the months ahead.

Figure 8. The globalisation of high yield

Bank of America Merrill Lynch, as at September 2019.

The high-yield market has also seen the birth of new types of instruments since the financial crisis, prompted by regulations brought in since 2008 (see figure 8). For example, the market for hybrids – instruments with debt and equity features – has grown from zero to $150bn in 20 years. Choosing the right part of the capital structure is clearly as important as selecting an attractive issuer or sector. 

Figure 9. A richer high-yield universe  

Source: Bank of America Merrill Lynch, as at September 2019.

Our preference for large, multi-layered capital structures also means that our holdings are likely to have more funding options available to them – such as the ability of hybrids to issue public equity – and should also have stronger relationships with banks, which will put them in a better place to withstand any turbulence in the months ahead.

ESG: impossible to ignore

Environmental, social and governance (ESG) analysis has become an increasingly important way to differentiate between active and passive high-yield strategies. While passive portfolios mostly focus on exclusions, an active approach allows investors to seek alpha by identifying where ESG risks have been inaccurately priced.

We have carried out research that demonstrates a negative correlation between a company’s ESG behaviours and its credit-default swap spreads. This relationship has become more significant over time, which suggests that as the market becomes more focused on ESG analysis the cost of funding could increase for companies with poor ESG behaviours.

The coronavirus pandemic has emphasised the need to integrate ESG into credit analysis. Companies do not operate in a vacuum and during this volatile period it is important to find well-run businesses that do not face ESG-related risks. ESG analysis can help protect against the downside and is particularly important during market downturns.

In addition to using external ESG ratings and our own in-house Quantitative ESG scores, our analysts use their in-depth knowledge of different sectors to price ESG risks. Analysts have a thorough knowledge of the sectors they cover, which means they are best-placed to assess whether these risks could occur. We also draw on the insights of our colleagues at EOS at Federated Hermes, who engage with companies to improve their long-term performance and to foster better, more sustainable business outcomes. This gives us an additional perspective on an issuer’s ESG risks and how they have changed over time.

Weathering the storm: seeking the upside in global high yield

We believe that the global high-yield market offers considerable opportunities in the months ahead. While defaults will likely tick up, the risk will be mitigated in part by central-bank stimulus and government support. High yield is also trading at valuations that history shows are often followed by periods of positive returns. Importantly, the obligation of high-yield credit to pay out coupons means it should recover more quickly and deliver returns earlier on in the macroeconomic cycle. In this turbulent and fast-changing environment, we will continue to take an active, flexible approach to seeking opportunities throughout the global high-yield credit spectrum.

  1. 1As measured by the VIX (Chicago Options Exchange Volatility Index)
  2. 2‘ECB's commitment to the euro has "no limits": Lagarde’, published by Reuters on 19 March 2020.
  3. 3ICE BofA Global HY TR USD and MSCI World NR USD. 1 April 2005 to 31 March 2020. Source: Morningstar, as at March 2020.

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