Asset Management: Multi-Asset Insights

Is the selloff in high-yield bonds warranted?

selloff-in-high-yield

It’s been a familiar pattern over the past several years. A global growth scare leads investors to flee the high-yield bond asset class in droves, resulting in a spread widening, negative short-term returns and an overestimation of default risk. Looking back at 2011, during the third quarter high-yield bonds (BofA Merrill Lynch U.S. High Yield Master II index) posted a total return of -6.3% on fears of a double dip recession in Europe and the possibility of a technical default by the U.S. government facing a shutdown. Spreads widened to 800 basis points, implying default rates over 10%. When reality set in and worst-case scenarios faded, defaults averaged less than 3%, spreads compressed and high-yield bonds finished at +4.4% in 2011 (+6.2% in the fourth quarter) and +15.6% in 2012.

Investors have overestimated default risk since the crisis
*Assumes a 2% risk premium and recovery rate of 40%; sources: BofA Merrill Lynch and MRB calculations
**Sources; Standard & Poor’s series shown thereafter
Note: Shaded for NBER (National Bureau of Economic Research) – designated recessions

Fast forward to 2015 and fears of a global growth scare are here again, led by China and a bear market in commodities. Again, outflows have followed as high-yield bond ETFs (exchange-traded fund) and mutual funds shed $3.9 billion over the last 13 weeks. This has resulted in the spread widening to 600 basis points, third-quarter returns of -4.9% and implied default rates in the 6%–7% range for ex-energy issues. Default rates of this magnitude would likely imply a recession, though in our view the U.S. economy is a long way from signaling one is on the horizon. Default rates have picked up recently, but rose to just 2.6% (annualized) in September.

This selloff leaves the broad high-yield market with a yield of 8%, which masks the bifurcation between commodity-linked sectors yielding 9%–14% and the broader asset class yielding 7%. This yield looks attractive when compared to Treasurys, particularly with a looming Federal Reserve rate hike. A hike would signal an economy strong enough to handle policy normalization, muted defaults and spread narrowing. Treasurys currently offer only a small income cushion given near-record-low starting yields. In contrast, high-yield bonds have averaged about 6% in annualized returns over the past five years, and that type of return is still possible looking out over the next couple years

The spread between high-yield bonds and Treasurys has widened by more than 1% in the last quarter. Collecting income at a rate four times that of Treasurys should reward patient, value-focused investors over the next 12 to 18 months.

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