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Fixed-Income Insights

An examination of the major issues surrounding the recent volatility in the sector—and their potential impact on investors 

 

In Brief

The sell-off in high-yield securities in July and August 2014 has likely raised questions about this sector of the fixed-income market. In this article, we address five areas of concern.

  • The causes—Historically narrow yield spreads versus U.S. Treasury securities likely prompted some profit taking. Geopolitical and credit-market concerns also may have contributed to the price declines.
  • Panic” selling?—The price declines seen in the recent downturn were far less than the “taper tantrum”-inspired selling (see article text) that occurred in May and June of 2013.
  • The role of ETFs—Widespread selling from exchange-traded funds (ETFs) that hold high-yield bonds likely contributed to the price volatility in July and August 2014.
  • Liquidity—The recent sell-off did not appear to reveal major liquidity issues. Fundamental conditions that could provoke a significant test of market liquidity do not appear to be present right now.
  • Fed impact—Amid Federal Reserve policy concerns, investors should note that high-yield bonds historically are less responsive to interest-rate changes than Treasuries or higher credit-quality securities.

 

The past few weeks have been rough for the high-yield bond market, as a sell-off pushed yields on the BofA Merrill Lynch U.S. High Yield Index to as high as 6.1% on August 1 from a record low of 5.2% on June 23, 2014, according to BofA Merrill Lynch index data cited by Bloomberg. During that period, yield spreads versus U.S. Treasury securities of similar maturity rose from a seven-year low of 335 basis points (bps) to 425 bps at the start of August. Data provider Lipper reported a record $7.1 billion outflow from high-yield mutual funds in the week ended August 6, far exceeding the previous peak of $4.6 billion in June 2013.

We’ll explore the factors behind the sell-off a bit later. But the size of the move appears to reflect the combination of redemptions from exchange-traded funds (ETFs) that invest in high-yield securities, and a reduced willingness by banks that act as dealers in these securities to offer them for sale. These factors likely created some minor liquidity issues, but the market did not appear to experience any outright liquidity gaps, whereby securities could not be sold. The reduction in liquidity did produce opportunities for active managers willing to reposition their portfolios to take advantage of ETF selling pressure.

The real test for liquidity in the high-yield market could come from a credit event that triggers broad-based selling. Right now, though, the market environment seems to be missing the criteria associated with fundamental credit concerns. Of course, the prospect of rising interest rates could pressure all sectors of fixed income. But it is worth remembering that, historically, high-yield securities have performed well relative to other fixed-income sectors in periods of Fed tightening or other rising-rate environments. [Although, high-yield securities may not perfrom in the same manner under similar conditions in the future.]

Given the recent developments in high yield, it would be natural for investors to have a number of questions about the current state of the market—and where next it might be headed. Here, we attempt to answer five of those questions.

1) What are the factors behind the recent sell-off in high yield?
After the high-yield sector delivered a first-half return comparable to what many investors expected for the full year, the asset class came under some selling pressure in early July, as historically narrow yield spreads versus U.S. Treasury securities likely prompted some profit taking. At the same time, a confluence of geopolitical concerns, primarily involving increased tension in Ukraine and the Middle East, caught investors’ attention. Further, comments from Fed chairwoman Janet Yellen that high-yield market valuations “appear stretched,” coupled with worries about defaults by Argentina and the Portuguese bank Banco Espirito, helped foster a “risk-off” mindset. This appeared to be especially true among retail investors, provoking large outflows from high-yield ETFs. The forced liquidation and somewhat indiscriminate, broad-based selling by ETFs pressured high-yield prices lower. The concomitant “flight to quality,” as investors sought the perceived safety of Treasury securities, resulted in an early August rally for U.S. government debt that pushed wider by 88 bps the yield spread of high-yield debt versus Treasuries.

What was missing from this sell-off was evidence of economic concerns specific to high yield, or signs of deterioration in widely followed credit-market indicators. What seemingly was ignored by investors throughout July was the improvement in fundamentals that could serve to balance geopolitical and valuation concerns. Stronger U.S. economic growth was announced by the Bureau of Labor Statistics (BLS) on July 30 in the form of second-quarter gross domestic product (GDP) growth of 4.0%. The growth story was also supported by continued improvement in the labor market, as the BLS reported on August 6 that a four-week moving average of initial jobless claims was at the lowest level since February 2006. Further, the July non-manufacturing purchasing managers’ index from the Institute of Supply Management (a widely followed gauge of service-sector activity)  reached its highest point since December 2005. 

Meanwhile, credit-market data in July also pointed to solid fundamentals for high yield. BofA Merrill Lynch data on 429 reporting high-yield companies showed a year-over-year second-quarter earnings improvement of 9.7% (based on the earnings before taxes, interest, depreciation, and amortization, or EBITDA). Data from JP Morgan placed the 2014 default rate on high-yield securities at 1.95% (but excluding the bankruptcy of Energy Future Holdings, the rate would have been 0.59%), well below the 3.9% long-term average. Credit ratings agency Standard & Poor’s reported an upgrade/downgrade ratio on high-yield debt issues of 1.7, compared with 1.0 in 2012 and 1.1 in 2013. Standard & Poor’s also reported that the ratio of “rising stars” (i.e., debt issues upgraded to investment grade from speculative grade) exceeded “fallen angels” (i.e., issues downgraded to speculative grade from investment grade) by a ratio of 3.0 in July and 2.4 for 2014 (through July 31), compared with 2.0 in 2012 and 1.9 in 2013. Taken together, these data points suggest that the high-yield sector is experiencing sustainable to improving credit fundamentals. If geopolitical concerns eventually prove to have a lesser impact on specific U.S. high-yield companies than what market participants appear to expect, current high-yield valuations may prove attractive.

2) The terms “shakeout” and “panic” have been used to describe the high-yield market in July. How bad was it?
July was the first negative month for the high-yield sector during the past 12 months, so in that respect it is noteworthy. But a bit of perspective is in order. The 1.33% negative return for July 2014 for high-yield funds was only about one-half the 2.62% decline in June 2013, based on the performance of the Barclays U.S. Corporate High-Yield Index. (Recall that June 2013 marked the worst month of the bond-market sell-off in response to former Fed chairman Ben Bernanke’s suggestion that the Fed might begin reducing its monthly bond purchases.) Redemptions of high-yield funds during this “taper tantrum” period, May 7–June 25, 2013, were $11.4 billion, similar to the $12.6 billion in redemptions in the four weeks ended August 6, 2014. Again, though, the market impact this year was a peak-to-trough move in the yield spread of 88 bps, less than half the rise of 192 bps for the period of May 7–June 26, 2013. 

To be sure, a yield-spread rise of 88 bps over a period of four weeks and a monthly return of -1.33%—when higher credit-quality assets improved in price—is neither an enjoyable experience nor one that investors want to extend. However, recognizing that it took the geopolitical and credit-market concerns cited earlier to bring about this correction, it may be surprising that the high-yield adjustment was not quicker and deeper. Considering that after the July–August sell-off, the year-to-date (through August 12) return on the BofA Merrill Lynch U.S. High Yield Index at 4.25% is not all that far below the coupon for many high-yield issues, “panic” may be the wrong term to describe the correction in the market.   

3) What has been impact of selling from ETFs?
Holdings of high-yield ETFs have grown from essentially nothing in 2007 to $35 billion by year-to-date 2014, or 11% of the high-yield fund universe. Because ETFs often are viewed as liquid investments with which investors can time their entrance and exit from the high-yield market, their contribution to price volatility can be far more than their size implies. Given that ETFs amount to just about one-ninth of high-yield fund assets, there were periods in July when ETFs accounted for more than 60% of redemptions, according to JP Morgan. On a weighted-average basis, ETFs accounted for about 45% of redemptions through the four weeks ended July 30, 2014.1 Even this understates the pressure on the high-yield market, when nearly identical high-yield issues must be sold by various ETFs under redemption pressure, with much less regard for price than for maintaining a now smaller portfolio that still must be representative of the high yield market it replicates. 

4) Have recent redemptions revealed liquidity constraints in the high-yield market?
Concerns about liquidity in the U.S. high-yield market appear to be based on the market impact of ETF redemptions, reduced capacity from firms that act as dealers in high-yield securities tied to Basel III capital requirements, proprietary trading limits related to the so-called “Volcker Rule” under the Dodd–Frank Wall Street Reform and Consumer Protection Act, and the general contraction in dealer inventories. To a large extent, the contraction in inventories reflects the consequences of Dodd-Frank and the adoption of capital standards under Basel III. The numbers are staggering. The Federal Reserve Bank of New York, for example, reports that dealer inventories of total corporate debt (investment grade and high yield) were $285 billion in October 2007. The bank’s latest report shows a total inventory of $37 billion as of July 30, 2014.

The good news is that financial intermediaries appear to be able to do more with less. Non-investment-grade inventories tracked by the New York Fed have been separated from all corporate debt inventories only since April 2013. Since that time, non-investment-grade inventories have ranged from $4.8 billion to $8.4 billion, totaling $8.2 billion, as of July 30, 2014. Dealer banks have been able to accommodate the effects of the Fed-inspired liquidations in 2013 and the high-yield flight-to-quality trades in 2014 without serious market consequences. At a time when high-yield ETF redemptions forced more visible and less discriminate sales than is characteristic of actively managed funds, the market was still able to function fairly well. Dealer banks, operating within the Basel III and Dodd-Frank constraints, and likely aided by some opportunistic buying from active management firms, lent some order to the price decline.

As mentioned earlier, the market ultimately avoided the potential liquidity gaps that many investors had feared. During the recent weeks of redemptions, active managers benefited from strong relationships with dealer banks and their knowledge of which buyers may be most interested in specific securities. Select illiquidity in specific securities or sectors under ETF selling pressure also allowed active managers to reposition portfolios and capture opportunities. 

A truer test of market liquidity than the July flight-to-quality trade will likely be a credit event that triggers much broader-based selling. Such an event is not likely to be a single credit default, but the perception that increased defaults might follow from a broad shift in fundamentals such as deteriorating issuer financials, a U.S. economic slowdown, increased corporate leverage, or rapidly rising costs, which could eat into company profits. Typically, such an end to the credit cycle includes three conditions: an overheated economy, a greater degree of leverage assumed by companies as they seek to take advantage of opportunities expected from excessive economic growth, and an aggressively restrictive central bank trying to curtail too-rapid growth and the high inflation that typically travels in its wake.  The environment seems to be displaying the opposite conditions right now. Investors are hoping for stronger economic growth, companies are refinancing debt at lower cost—though with rising levels of cash on corporate balance sheets, they seem to have less need for leverage—and the Fed is on a slow path toward finally raising rates—not to restrict growth and inflation but to get to a more normal interest rate structure.

5) If the Fed is on a path to normalize, or raise rates, won’t that also impact high yield?
A hike in the fed funds rate, or higher yields on Treasuries, certainly could affect high-yield bonds. But it is important to note that high-yield securities are less responsive to changes in interest rates and more economically sensitive than Treasuries or higher credit-quality securities. If the Fed raises rates gradually, as conditions permit and as it has done till now, the economic strengthening necessary for higher rates could support investor expectations of continued credit improvement and reduced likelihood of defaults. We have seen, historically, this behavior reflected in high-yield prices. As Table 1 shows, during each of the three Fed tightening periods within the past 20 years, high-yield bonds have not always provided positive returns, but hey have proven a better fixed income alternative than other options.

 

Table 1. How Have Select Bond Market Sectors Performed During Rate-Hike Episodes?
Total return by category during indicated periods of Federal Reserve rate hikes

Source: Bloomberg, BofA Merrill Lynch, Credit Suisse, and Morningstar.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. Investors may experience different results. Due to market volatility, the market may not perform in a similar manner in the future.
Past performance is no guarantee of future results. Please see below for information regarding economic indicator data and index information.

 

The prospect of rate adjustments by the Fed over the next few years could be even more advantageous to the high-yield sector than past tightening moves by the Fed if the modest pace of rate hikes gives high-yield securities (with their higher coupons offering an increased level of income) time to contribute relatively more to total return.

Instead of restricting our focus to just Fed rate hikes, we can look at other periods of rising rates and find that high yield again has performed relatively well. Over the past 20 years, there have been seven periods when the 10-year Treasury yield has increased by at least 100 bps within 16 months. In each of those periods (see Table 2), high-yield securities rose measurably less in yield than 10- year Treasuries or, in several cases, actually declined in yield.

 

Table 2. High Yield Has Outperformed Treasuries in Past Periods of Rising Interest Rates
Yields on the Credit Suisse High Yield Index and the 10-year U.S. U.S. Treasury note during the last seven periods of rising interest rates

Source: Credit Suisse and Bloomberg.
*High yield declined in yield (rose in price) as Treasury yields rose (declined in price).
Past performance is no 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 Lord Abbett mutual fund or any particular investment. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

This behavior suggests that in such a rising interest-rate environment, high-yield securities not only have offered higher income than Treasuries but also better price performance. While better price performance may not always be absolutely positive, on a relative basis, high yield has performed relatively well during periods of rising rates. That’s something for farsighted investors to think about as the dust settles from the high-yield market’s summer sell-off.

 

1"Weekly Fund Flows,” EPFR Global, August 8, 2013.
2The 2004–2006 period indicates three-year average annual returns.
3BofA Merrill Lynch U.S. Corporate Master Index.
4BofA Merrill Lynch High Yield Index.

 

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