Whilst a rising interest rate environment and the prospect of tapering puts upward pressure on underlying government yields, a benign economic environment continues to favour the outlook for corporate debt. In these extraordinary times for bond markets and central bank activity, is high yield debt still a good bet?
The bulls point to a ‘Goldilocks’ economic scenario. Weaker corporate entities can muddle through and remain solvent, owing to their ability to refinance cheaply. This has reduced the cost of debt for such companies to near-record low levels.
It also means that most companies with a poor credit rating can (theoretically) look to the future with optimism. In all likelihood, default rates should remain low, as some high yield companies now exhibit stronger balance sheets, as their refinancing pushes out maturities beyond 2016.
Furthermore, since high yield debt tends to have lower duration, the return on their original investment will be higher but also quicker (provided the company does not default). For one to remain optimistic on high yield debt into the future, however, we need to make two key assumptions.
First, we suppose that the rising interest rate environment will be very gradual and on the back of strong economic growth. And second, we presume that spreads will narrow further from current levels, in order to negate the impact of rising government bond yields. History demonstrates that high yield debt has a much stronger correlation with equities than that of government bonds or investment grade bonds. If one is positive on the outlook for equities, high yield debt might look attractive.
But this should not suggest that the strong returns of yester-year can be repeated. The greatest concern is that, following four years of ZIRP and demand flows into the asset class, high yield valuations look overstretched, suggesting downside risk. Yields are at near-record lows, and spreads are not much better than fair value in most areas.
Given that underlying government yields have been artificially suppressed, any talk of tapering might expose these risks and a back-up may well be in the offing.
Investors should also consider the default expectations that high yield debt is reflecting. Whilst investment grade debt is now pricing in a five-year implied default rate, in excess of the historical average since 1970, high yield debt is pricing in relatively average levels of default. This reinforces the argument that there is limited downside protection for high yield investors at current levels.
Investors are also right to be concerned about increasing levels of complacency in the underwriting of new debt issues within the high yield space – a problem that prefaced the credit crunch and exposed the most vulnerable companies.
Although we have not yet reached these levels, investors’ should be mindful of the risk. Spreads have also continued to narrow, when reviewed in tandem with the amount of debt held by issuing companies. Spreads have narrowed by a smaller magnitude and leverage has been on the rise, as companies continue to take advantage of low rates.
The way in which this debt is used is also very important for bond investors, who should be wary if more companies borrow money to buy-back stock or carry out mergers and acquisitions (both “bond unfriendly” actions).
The economic environment should continue to support low default rates for weaker companies in the near term, and central banks will remain accommodative. But we suggest not adding to high yield debt exposure at current levels. Indeed, we are mindful of signals of financial stress or any meaningful deterioration in the quality of debt underwriting, at which point we would materially reduce our own exposure.