Fixed Income | Investment Manager Research | COVID-19
The Case for High Yield Credit
May 17, 2020
Financial markets came under significant pressure in the wake of the coronavirus pandemic as governments around the world “closed” economies to stop the spread of the virus. Markets witnessed a widening of corporate credit spreads as investors grappled with the uncertainty surrounding the impact shutdowns would have on corporate financial health and the ability for borrowers to pay back their debt. As spreads moved wider, bond prices move lower and subsequently reached a level that we believe offers an attractive entry point into the corporate high yield market.
High yield bonds are debt securities issued by companies with credit ratings below investment grade (typically BB and below). In order to compensate investors for greater risk of default, these bonds typically offer a higher coupon relative to U.S. government or investment grade debt. High yield bonds typically exhibit greater volatility relative to investment grade. These traits also mean that high yield bonds typically exhibit lower correlations to traditional fixed income sectors, largely driven by their higher credit sensitivity (i.e. default risk) and lower sensitivity to interest rates. However, high yield corporates are more correlated with equity securities as a function of higher idiosyncratic business risks priced into the asset class.
The “spread,” or incremental yield offered over similar duration Treasury issues, can vary based on several items, including both fundamental and technical factors. Fundamental factors can include issuer-specific credit concerns or more general thoughts on the overall economic environment. At times, bond prices can deviate from what fundamental conditions would suggest, overshooting to either the upside or downside based on supply and demand imbalances. The universe is also significantly smaller, and less liquid relative to investment grade, comprising approximately $1.1 trillion1, relative to the $9.5 trillion in total corporate bonds outstanding as of 20192.
These technical conditions can lead to periods where investors are offered greater compensation than they would otherwise expect, given their expectations for the economy or potential defaults. This occurred to a significant extent during the Great Financial Crisis of 2008 and 2009 when high yield bond spreads reached 2000 basis points, suggesting default levels would be multiples higher of what was experienced in the past. While the recession proved to be challenging, the default cycle ultimately never matched the depth of the trough in the economic cycle or justified the levels that spreads reached.
High Yield Spreads and Subsequent Returns
While that opportunity was unique, history indicates over the last several credit cycles, when high yield bond spreads approach 800 basis points, it proves to be an attractive entry point for the asset class. Current spread levels in the high yield arena are now at approximately 750 basis points, well above the ten-year average of 480 basis points. Spreads at these levels imply that annual defaults will be in the 8 percent to 12 percent range, with a five-year cumulative rate nearing 50 percent. Said another way, defaults would need to reach these levels for investors to be indifferent between investment grade bonds and high yield bonds due to their yield advantage.
1ICE BAML HY 2019
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