High Yield Spreads Aren’t as Narrow as They May First Appear

While high yield bonds’ yield to maturity may be close to historic lows, credit spreads themselves are not, particularly when adjusted for favorable changes in credit quality and duration.

In Brief:

• High yield has had an enviable run this year leading to debates on whether or not credit spreads can narrow from here given recently uneven economic data.
• Any discussion on spread direction needs to acknowledge that the high yield market has improved in credit quality (as measured by composite ratings) and shortened in duration over the past decade. Both argue for tighter spreads when compared to historical sign posts.
• We maintain a constructive view on the asset class, in light of reasonably benign credit conditions, an accommodative Federal Reserve, and few concerns about fundamental corporate credit quality in the high yield bond market.

Just how far through a credit cycle the U.S. economy has progressed, the timing of any potential contraction, and the general health of corporate balance sheets are all part of our discussions with clients today. As a result, we find investors scrutinizing the risk premium embedded in equity and credit markets alike.  Specifically within the U.S. high yield market, a 153 basis point (bp) rally in the overall market index option-adjusted spread (OAS) year-to-date (as of September 30, 2019), which contributed to a 11.2% total return (also as of September 30, 2019), has market participants wondering if there is much opportunity left for high yield credit spreads to narrow from here.

In this case, we believe a longer term perspective is warranted. We start by noting that there are many drivers of credit spreads. Compensation for potential idiosyncratic credit deterioration or eventual default, as well as for relative liquidity, financial market volatility, and systemic risks all contribute to an overall credit spread. Additionally, the overall dollar price of the asset class as well as yields can influence spreads given embedded call options in most high yield bonds.

We believe it is also worth highlighting, however, that the high yield market has gotten both higher in quality and shorter in duration over time. These two important developments positively affect our assessment of today’s starting point of credit risk and hence, risk premium, all else being equal.

Quantifying the Increase in Credit Quality and How That Affects Comparisons to History
While the popular press has focused on the growth of the corporate debt markets over the last decade, the climb in margins and profitability matter as well. In Chart 1, we compare the distribution of ratings across the high yield market today versus right before the start of the last recession, otherwise known as the Global Financial Crisis, between 2008-09. Two points are clear. First, the relative weightings of “BB”-rated and “B”-rated  bonds have essentially swapped, with BBs now making up the majority of the asset class today.  Secondly, the percentage of bonds non-rated or CCC+ or below is just 15% of the overall high yield market today versus 21% at the spread trough in 2007.

Chart 1. BBs are Now the Largest Segment of High Yield While CCCs Have Shrunk in Proportion

Source: The Bloomberg Barclays U.S. Corporate High Yield Bond Index. 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. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

Chart 2. Wider Overall Index Spreads Today Versus Pre-Crisis Have Been Driven Primarily by Bs and CCCs

Source: The Bloomberg Barclays U.S. Corporate High Yield Bond Index. 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. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

Chart 2 shows the difference in the OAS by ratings cohort today versus the pre-crisis period. More specifically, we show the valuations at that earlier point in time as the average OAS for each rating cohort over the 12 months leading up to June 2007 when spreads bottomed for the cycle. While BB spreads today are comparable to the pre-crisis tights, the spread curve by quality is far steeper now (as of September 30, 2019), with both Bs and CCCs meaningfully wider than their pre-crisis levels.

To further illustrate changes in relative value by rating cohort over time, Chart 3 tracks each rating cohorts’ OAS as a percentage of the overall high yield index spread. While the time series following B-rated spreads essentially matches the overall market spread over time (i.e., a ratio of around 1.0x), the ratios for BBs and CCCs have gone in opposite directions, particularly since the middle of 2018, toward their historical extremes.

Chart 3. BB and CCC Spread Ratios Have Moved Toward Their Historical Extremes
(June 2006-September 2019)Source: The Bloomberg Barclays U.S. Corporate High Yield Bond Index. 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. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

Finally, we can use these observations on the improvement in the overall ratings mix of the high yield bond market and spread comparisons versus the pre-crisis period to more properly calibrate today’s valuations in an apples-to-apples comparison to history. Specifically, if we consider today’s ratings mix and apply the trailing 12-month average prevailing spread by rating cohort as of June 2007, we come to an approximate theoretical index spread of 270bp (compared to today’s actual high yield index spread of 373bp (as of September 30, 2019). Obviously, the cheapness of CCCs today versus 2007 explains much of the gap, but we note that the B/high yield index ratio has been lower in the past as well. We simply present this approach to suggest that there is capacity for spreads to move modestly to much tighter from today’s levels, all else equal, just given the overall improvement in credit quality of the high yield market today. But there’s another effect to consider as well that builds further on that intuition – the decline in duration of the high yield market when compared to history.

Chart 4. Calibrating Today’s High-Yield Bond Valuations for Improvement in Ratings Suggests Potential for Tighter Spreads, All Else Being Equal

Source: The Bloomberg Barclays U.S. Corporate High Yield Bond Index, Lord Abbett & Co LLC. 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. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

Quantifying the Decline in Duration
As much debate as there is on the direction of high yield spreads today outright, market participants also debate the scope for further compression between the investment grade and high yield market OAS. We won’t go through a relative value discussion between these two segments of the corporate credit markets here. But in Chart 5 we show that while the duration of the high yield market has shortened by over 1/3 since 2007, the duration of the investment grade corporate market has gone in the opposite direction.

Why the fall in high yield’s duration? A few factors are prominent. Management teams of high yield companies have modestly shortened the maturity of their issues in the primary market as the high yield and leveraged loan markets have matured over time with a broader and deeper investor pool. That maturing process has helped mitigate some historical concerns about new issue markets seizing just as issuers need to refinance maturing debt. Second, issuance in the high yield market has been tame the last several years (with the exception of the year-over-year growth this year) as issuers either pivoted to issue in the leveraged loan market or alternatively kept debt growth restrained outright. That lack of growth of bonds outstanding has led to a general rolling down the curve of issuers’ bonds. And finally, the rally in rates this year has led to a growing proportion of callable high yield bonds trading to their near-dated call price as bond prices have climbed.

All else being equal, we believe this shortening in duration is supportive of tighter credit spreads when compared to history. Because uncertainty and default risk generally increase over time, the term structure of credit spreads is typically positive. Shorter duration bonds usually carry less credit risk than like quality longer duration bonds. And as the high yield market’s duration has shortened, that leaves fewer potential paths over this shorter period of time for an issuer’s bonds to experience significant credit deterioration or a jump to default. Additionally, this shorter duration leaves the high yield market less vulnerable to a sharp reversal in benchmark U.S. Treasury yields should they reverse after this year’s powerful rally.

Chart 5. The Duration of the US High Yield Market Hits New Lows Just as the U.S. Investment Grade Corporate Market Duration Has Been Climbing
(September 2007-September 30, 2019)
Source: Bloomberg Barclays Indexes. Data as of September 30, 2019. 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. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

How does this fall in duration impact our assessment of value? In Chart 6, we find that all the ratio of high yield index spread per unit of duration has climbed recently as the general narrowing in spreads has not fully offset the fall in duration. Indeed, today’s high yield index spread per unit of duration of 122bp (as of September 30, 2019) is just above the median observed, either including or excluding the 2007-2009 period.

Chart 6. U.S. High Yield’s Spread Compensation Per Unit of Duration is In Line with the Long-Term Median; Slightly Above Median When Excluding 2007-2009

Source: The Bloomberg Barclays U.S. High Yield Corporate Index. Data as of September 30, 2019. 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. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

Implications for the Way Forward
Our discussion here is meant to provide some historical context to current high yield valuations. Risk-free benchmark yields have fallen across the globe, bringing risky asset yields lower with them. But it is important to more carefully calibrate how credit investors are being compensated for the credit risk component in high yield bonds. Simply, while high yield bonds’ yield to maturity may be close to historic lows, credit spreads themselves are not, particularly when adjusted for favorable changes in credit quality and duration since the onset of the financial crisis.

While the default rate may have bottomed for this cycle, we believe the flow through of accommodative monetary policy yet to be realized, credit supportive growth despite moderation, and corporate conservatism on balance sheets broadly (if not universally) suggest an extension of the credit cycle. As high yield spreads have largely vacillated in a range this year, we have been disciplined around positioning, currently modestly underweight BBs where we see little incremental value, and instead allocating further down the credit spectrum building on the expertise of our credit research process. We believe this unconstrained and flexible approach to managing credit risk is particularly effective now given valuations and an admittedly modestly choppier macro backdrop.

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High-yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, interest-rate, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. Lower-rated bonds may be subject to greater risk than higher-rated bonds. No investing strategy can overcome all market volatility or guarantee future results.

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.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

A basis point is one one-hundredth of a percentage point.

Call options are financial contracts that give the option buyer the right, but not the obligation, to buy a stock, bond, commodity or other asset or instrument at a specified price within a specific time period.

Duration is an approximate measure of a bond's price sensitivity to changes in interest rates. 

The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst uses the Treasury securities yield for the risk-free rate.

A risk premium is the return in excess of the risk-free rate of return an investment is expected to yield;

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).

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

The Bloomberg Barclays U.S. Corporate High Yield Bond Index is a market value-weighted index which covers the U.S. non-investment grade (rated BB or lower) fixed-rate debt market. The overall index is also subdivided into separate ‘BB’-rated, ‘B’-rated, and ‘CCC’-rated components.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities 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 principle on these securities.

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.

The opinions in this article 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. Readers 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. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.