Exploring Fresh Opportunities in U.S. High Yield Credit
July 20, 2020
With record amounts of investment-grade companies falling into the high yield category, and unprecedented action by the U.S. Federal Reserve, we believe there are opportunities across the credit spectrum.
Read time: 3 minutes
Like other risk markets, U.S. high yield saw a sharp correction in February, followed by a strong rally sustained since the end of late March. There are some key factors driving recent performance, the U.S. Federal Reserve’s (Fed’s) programs as well fiscal support among them. We’ve also seen improvement in the overall quality of high yield, with record amounts of "fallen angels" in 2020, which has created opportunities across the credit spectrum. With a pandemic slowing the re-openings of cities throughout the United States, there are several considerations for strategic positioning within high yield, now and in the long run.
Recent High Yield Market Performance
As the COVID-19 pandemic made its way around the world, extreme market volatility followed. Specifically, in high yield, the ICE BofA U.S. High Yield Index was down about 20% year to date as the market bottomed March 23. Investment grade bonds also saw double-digit declines. Now, high yield is up 20% from those earlier lows and has taken a bit of a pause.
We attribute the most recent performance to two key factors: The cyclical nature of the asset class and more direct exposure to COVID-impacted sectors. While energy is still the largest sector in high yield, transportation and leisure are a growing part of it, given recent new issuance and fallen angel downgrades. Overall, supply and demand for high yield has been fairly balanced, with strong inflows and record monthly issuance levels in May and June, according to data from S&P Global. The strong amount of issuance (see Figure 1) and access to capital markets is something we believe is a sign that downside risk in high yield is limited over the intermediate term as management teams work to build liquidity as a buttress against any resurfacing economic pause.
Figure 1. U.S. High Yield Issuance Reached a Record in the 2020 Second Quarter Quarterly gross new issuance for 1Q 2010–2Q 2020
Source: JPMorgan Index data. The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results.
Potential Opportunities Across the Credit Spectrum
We think the near-term opportunity skews higher quality. According to ICE BofA index data, the spread on the highest-rated segment of high yield, BB-rated bonds, was still in the neighborhood of 450 basis points (bps) as of July 15; in higher-quality B-rated bonds, spreads are in the 500-600 bps range. In the very near term, we believe there is room for spread tightening for BB bonds, but particularly for fallen angels, which as original issue investment grade credits generally don’t face the same negative convexity from call prices as do legacy high yield bonds.
It’s important to note here that not all fallen angels are created equal. Thus, it is imperative to differentiate winners from losers. Our team structure at Lord Abbett, which consists of a consolidated group of research analysts that cover the entire credit spectrum, is something we believe is well-positioned to identify opportunities in the space.
Figure 2. High Yield Spreads Have Recovered Significantly Since Late March
Spreads on the ICE BofA U.S. High Yield Index, June 30, 1995–June 30, 2020
Source: ICE Data Indices, LLC. Yield spreads represented by the ICE BofA U.S. High Yield Constrained Index. Past Performance is not a reliable indicator or guarantee of future results. It is important to note that the high-yield market may not perform in a similar manner under similar conditions in the future. The historical data shown in the chart above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. Bps represents a basis point. One basis point equals 0.01%.
As for specific sectors within high yield, we’ve been looking at the market in three distinct segments, according to different levels of reopening within the United States economy. Phase one, for example, consists of what we call high quality secular winners, such as cable, wireless, technology and health care. These are the companies that benefited from a transition to working remotely, and which we believe have defensive characteristics to withstand market headwinds. Phase two encompasses what we classify as the “soft reopen” sectors, a handful of cyclicals that we think are turning into secular growth stories. We see two important trends at work: families desiring to leave crowded urban areas for suburbs, and commuters wishing to avoid public transit when returning to the office. Thus, we’re seeing a V-shaped recovery in home builders and automotive firms, and think this could be a multi-year trend. Phase three is where we place COVID-impacted sectors, such as airlines, cruises, gaming and lodging. In airlines and lodging especially, we’re seeing a greater negative impact as COVID cases increase. And for now, our positioning remains generally more defensive there.
Default Rates and the Outlook for U.S. High Yield
When considering high yield defaults, we believe we won’t see default rates reach the levels we saw during the global financial crisis. The Fed’s monetary and fiscal support directly benefit high yield, in our view. Access to capital markets and record issuance also contribute to this generally positive outlook, as does the growing representation of BB-rated bonds and shrinking share of CCC-rated bonds in the U.S. high yield space. Finally, we encourage investors to take a less tactical approach to high yield and focus more on strategic positioning within the asset class – as always, ‘time in the market’ overrides ‘timing the market’.
The views and opinions expressed are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Listeners should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal.
Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future.
Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.
A Few Words About Risk
Bonds are affected by interest rate movements. Bond prices and, likewise, a bond fund’s share price, generally move in the opposite direction of interest rates. As the prices of bonds in a fund adjust to a rise in interest rates, a fund’s share price may decline. In addition, bonds are subject to call, credit, liquidity, interest rate, and general market risks. Investors should be aware of the special risks involved with investments in high-yield bonds. High-yield bonds invest in lower-rated, higher-yielding instruments, which are subject to increased risk of default and can potentially result in loss of principal. Higher-yielding, lower-rated corporate bonds entail a greater degree of credit risk than investment-grade securities. Adverse conditions may affect the issuer’s ability to pay interest and principal on the securities. Lower-rated bonds may carry greater risks than higher-rated bonds. Mortgage-backed securities are susceptible to prepayment risk.
Please note: The credit quality of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from AAA (highest) to D (lowest). Bonds rated BBB or above are considered investment grade. Credit ratings BB and below are lower rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities. The credit quality distribution breakdown is not an S&P credit rating or an opinion of S&P as to the creditworthiness of the portfolio.
Glossary of Terms
A basis point is one one-hundredth of a percentage point.
Fallen angels are bonds that have been downgraded from investment grade to speculative grade status.
Spread is the percentage difference in current yields of various classes of fixed-income securities versus Treasury bonds or another benchmark bond measure. A bond spread is often expressed as a difference in percentage points or basis points (which equal one-one hundredth of a percentage point).
The ICE BofAML U.S. High Yield Constrained Index tracks the performance of US dollar denominated below investment grade corporate debt publicly issued in the US domestic market.
ICE BofA Index Information:
Source ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES AND RELATED DATA ON AN “AS IS” BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD ABBETT, OR ANY OF ITS PRODUCTS OR SERVICES.
Indexes are unmanaged, do not reflect the deduction of fees or exposures, and are not available for direct investment.
The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.
Any mention of the "Fed" in this in this material refers to the U.S. Federal Reserve. Market related discussions are generally based on the U.S. markets and related U.S. policies except where otherwise noted.
Note to European Investors: This communication is issued in the United Kingdom and distributed throughout Europe by Lord Abbett UK Ltd., a Private Limited Company registered in England and Wales under company number 10804287 with its registered office at Tallis House, 2 Tallis Street, Temple, London, United Kingdom, EC4Y 0AB. Lord Abbett UK Ltd (FRN 783356) is an Appointed Representative of Duff & Phelps Securities Ltd. (FRN 466588) which is authorised and regulated by the Financial Conduct Authority.