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Fixed-Income Insights

With the broad financial market recovery since late March, U.S. high yield is no longer as dislocated, but the rationale for a strategic allocation to the asset class remains intact in our view.

Read Time: 14 minutes

 

In Brief:

  • The rally in U.S. high yield has been fierce, but not particularly out of step with other asset classes.  We remain constructive on the asset class through both some modest price appreciation potential that remains, along with income.    
  • The U.S. high yield market is now the highest rated high yield market ever with “BB”-rated credits currently the biggest rating category, while also leading in the recovery. Within BBs, select so-called fallen angels are leading the way.
  • Scrutiny within “CCC”-rated bonds is always warranted as the vast majority of defaults over a one-year horizon have come from this ratings cohort. A “fatter tail” of low CCC bond prices today suggests potential defaults may already “be in the price” for many stressed issuers.

 

Risky asset markets have witnessed a strong rebound since the late March 2020 lows, fueled by a combination of 1) historic fiscal and monetary support globally, 2) an associated gradual resumption (albeit staggered) of economic activity both within the United States and abroad, and 3) a parallel process of some progress on the race for both a vaccine and anti-viral therapies for the prevention and treatment of COVID-19.  U.S. high yield credit is no exception to this recovery as both an exhibit and beneficiary of the associated easing of financial conditions. But this whipsaw in valuations has left many investors wondering if there is still merit to an allocation to the asset class.

First, at the market level - It’s not just about spreads being above average…

We recently suggested that high yield credit spreads in late March reflected too dire an outcome around potential defaults and losses in years to come, and that there was excess liquidity premium to be harvested by investors with a strategic mindset.  We still do not believe the defaults to come over the coming years will cumulatively rank as the worst high yield credit cycle over recent history, but that’s no longer implied by credit spreads either.  A look at cross-asset valuations may help.  High yield spreads have largely rebounded to levels consistent with those observed earlier this year when major equity indexes were around current levels.  Focusing more closely within credit in Figure 1, we see the ratio of high yield to investment grade credit spreads is just marginally above its 10-year median, helping to put the spread rally into a cross-asset context. A similar chart of BB versus BBB spreads would suggest value in high yield as well with the BB/BBB ratio above its trailing 10-year median.   

 

Figure 1: The Spread Ratio of U.S. High Yield to Investment Grade is Still Marginally Above the Long-Term Median
Ratio of high yield to investment grade credit spreads (June 2010–May 31, 2020)


Source: ICE BofAML US High Yield Constrained Index, ICE BofAML BBB US Corporate Index. Data (latest available) as of May 31, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does 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. 

 

In Figure 2, we revisit an observation we first made late last year, specifically that the high yield market has continuously improved in quality, with BBs today comfortably comprising over one-half of the ICE BofAML U.S. High Yield Constrained Index – the highest proportion ever.  Similarly, the weighting of CCCs is less than three percentage points above its 20-year low experienced in early 2000 (as well as meaningfully lower than it was on the eve of the 2008-09 financial crisis).

The high yield market has entered this cyclical downturn from a position of relative strength compared to other cycles, at least as gauged by starting ratings.  Simply, an overall valuation proposition of high yield spreads of approximately 580 basis points (bps) (as of June 9, 2020) represents a higher quality underlying opportunity set (again as measured by ratings) than at other points in time when the overall high yield spread valuation was in a similar context.  That quality improvement merits consideration when looking back to the spread history of a lower quality mix in the past.  

 

Figure 2: High Yield’s Credit Quality Profile Has Improved Materially Since the Last Recession
Composition of the ICE BofAML US High Yield Constrained Index by ratings category for the indicated dates

Source: ICE BofAML US High Yield Constrained Index. Data (latest available) as of May 31, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does 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.

 

How have these ratings cohorts fared in the recovery over the last two months? Somewhat unevenly, as shown in Figure 3.  Investors’ uncertainty and still-defensive posture has manifested itself in a preference for the higher quality buckets of BBs and Bs while CCCs await broader sponsorship even with their recent rally. We will have more to say later regarding the drivers of performance and dispersion of CCC valuations we see today. But we believe the alignment of credit and equity investors’ interests that we see now still allows for “equity-like” upside in credit with the relative downside protection of being a creditor.

Admittedly, with the price of the ICE BofAML US High Yield BB Index essentially at par, investors may be thinking of forward returns there as more driven by coupon income than price appreciation.  That’s typically the case in high yield across all ratings cohorts. And it would be consistent with the observation we’ve made in the past – long term experience reminds us all to be more strategic and less tactical in thinking about a high yield allocation. But we remind investors that fallen angels (largely consisting of fixed maturity bullet bonds) within the BB category for the most part do not suffer from the same negative convexity of traditional high yield callable bonds.  For comparison, consider that the price of the ICE BofAML BBB US Corporate Index is currently approximately $110. And as we next discuss, look for more potential price appreciation within this sub-segment of BBs in particular.

 

Figure 3: BB Index Back to Par, but Fallen Angels aren’t Call Constrained; CCCs Wait for Broader Sponsorship That Could Come with a Focus on “Value” Stories

Source: ICE BofAML US High Yield Constrained Index. Data as of May 31, 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does 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.

 

…and fallen angels remain an alpha opportunity in higher quality high yield

The discussion around opportunity at the border of investment grade and high quality high yield is particularly timely today given over $175 billion of fallen angel volume year-to-date.  We’ve held that fallen angels provide fertile ground to provide alpha to high yield strategies as this artificial divide between the credit market segments of investment grade and high yield creates inefficiencies in terms of differing technicals created by investor flows.  That reality creates a long-term opportunity as many fallen angels work to regain their investment grade status in years to come. 

Further, we’ve pushed back on some of the concerns many investors had in the recent past about the threat to high yield from perceptions of a potential “flood” of BBBs to come. Figure 4 shows the outperformance of fallen angels over the last three major default cycles. The early outperformance of fallen angels in 2008 reversed soon after the cycle’s spread peak as subordinated bonds of financials remained under pressure through early 2009. But the profile of outperformance after market bottoms in 2002 and 2016 were quite similar through the first 100 days of the credit spread turnaround (both showing approximately 10% of outperformance by fallen angels versus the broader BB index). The year 2016 provides a particularly interesting parallel to today, with energy companies comprising a significant source of fallen angels then as well as now.

 

Figure 4: An Index of Fallen Angels has Outperformed the Overall BB segment of U.S. High Yield After the Past Three Spread Cycle Peaks

Source: ICE BofAML US Fallen Angel High Yield Index and the ICE BofAML BB US High Yield Constrained Index.  Trading Day  defined as spread wide for each respective cycle: October 11, 2002; December 19, 2008, and February 11, 2016.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does 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.

 

But in our view active management remains a necessity in this opportunity set as not all fallen angels are created alike. Consistent with the 2016 experience, many once investment grade energy credits specifically in the exploration and production (E&P) subsector have led the way higher again since late March as oil prices rebound and the highest quality credits remain well positioned to recover over coming years.  Meanwhile fallen angels that may face secular headwinds for longer, including Macy’s, Royal Caribbean Cruises, and Delta Airlines, have had to resort to raising “rescue” financing in the secured bond market, offering specific collateral to entice providers of credit.  [References to individual companies are for descriptive purposes only and do not reflect opinions on their investment merits.] For example, Continental Resources’ 2023 bonds have rebounded nearly $40 from their early April low to $95,  while Macy’s 2024 unsecured bonds have rebounded just $9 to approximately $75, with the latter hamstrung by a layering deeper in the capital structure by Macy’s recent secured bond offering.

Even within the same sector, the reception to fallen angels can be different based on their relative operating and financial flexibility.  For example, again in the E&P subsector, upon the onset of pressure in energy, bonds of fallen angels Apache Energy and Occidental Petroleum both fell from over par to around $50.  However, Apache has outperformed with bonds rebounding back into the low $90s, while Occidental lagged through the end of May as we see in Figure 5.

 

Figure 5: Fallen Angel Performance Can Vary Considerably – Choose Wisely

Source: Bloomberg. Data as of May 29,2020.  APA=Apache; OXY=Occidental Petroleum.  M=Macy’s. CLR=Continental Resources.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does 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.

 

CCCs: a small part of high yield but more disperse than before

As noted earlier, the proportion of the high yield market comprised of CCCs is near a historic low.  Why does that matter?  Most simply, when we consider one of the biggest performance drags on the asset class, it comes from the price declines down the path to eventual defaults or restructurings. In Figure 6, we track the cumulative default experience of the BB, B and CCC ratings groups of the 2000 and 2007 high yield market cohorts as they represented the worst five-year cumulative default experience over the past 20 years. As the chart suggests, the highest intensity of default experience comes from CCCs, with comparatively fewer defaults coming from BBs and Bs. 

 

Figure 6: Default Intensity is Highest with CCCs, as BB and B Defaults Within a Year Are Rare
Cumulative default count for each rating category starting in 2000 and 2007

Source: Lord Abbett, Moody’s.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does 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.

 

So that raises the question of what makes up the CCC space now? In Figure 7, we break down the market value of the top 10 sectors represented in the ICE BofAML CCC & Lower US High Yield Constrained Index at three distinct points in time: again the start of 2000, 2007 and today.

 

Figure 7: Comparing the Composition of CCCs at the Onset of Default Cycles
Composition by market value of ICE BofAML CCC & Lower US High Yield Constrained Index sectors as of each date

Source: ICE BofAML CCC & Lower US High Yield Constrained Index. Data as of May 2020.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does 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.

 

One observation from Figure 7 is that the CCC industry composition is less concentrated today than it was in 2000 (as well as in 2007) when fully 25% of the rating category was represented by one sector – telecom.  Given the sector-wide overspending and common industry challenges post Y2K, it’s not surprising the high yield cohort from that time represented the worst five-year cumulative default count over the last 20 years.  Today, the CCC rating composition is more diverse, with healthcare (largely hospital chains and health service facilities) representing the largest sector, followed by energy, and capital goods.

We believe any allocation to CCCs has to be less about gaining exposure to lower quality credit generically, but more so a deeper dive and sector focus to differentiate among the potential survivors and casualties in this default cycle. Indeed our approach to the cohort and driver of outperformance has long emphasized avoiding the troubled credits that go on to default rather than adding beta to the portfolio through a broad brushed approach. All in, a more diverse sector representation in CCCs (and their collectively representing a relatively small proportion of the high yield market) should help put guardrails around the more bearish default outcomes investors may have, in our view.

Finally, as we see in Figure 8, today’s CCC valuations are more disperse than when compared to other prior periods of high defaults (the early 2000 cycle and the 2008-09 financial crisis). In particular, the existence of  today’s comparatively “fat left tail” at wider spreads/lower prices suggests investors have been more discerning in the rating category and that potential default may already “be in the price” for many stressed issuers. This tiered pricing may subsequently present less downside risk to returns due to price declines that have already taken place in our view.

 

Figure 8: CCC Valuations are More Disperse Today When Compared to Other Similar Periods

Source: ICE BofAML CCC & Lower US High Yield Constrained Index, Lord Abbett & Co LLC. Data as of May 31, 2020.
Note: Periods of comparable CCC index spread valuations include: 7/31/00 @ +1634bp, 7/31/09 @ +1573bp, 12/31/2015 @ +1658bp and 5/31/20 @+1500.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does 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.

 

Wrap up

While high yield valuations aren’t as tempting as they were late in the first quarter of 2020, a look to cross-asset relative value can help reinforce the strategic rationale for an allocation for high yield. Even as high quality high yield overall becomes more of an income proposition now, we still see fallen angels as a having price appreciation potential.  But sector specific challenges will mean an active approach is warranted.  Meanwhile, at the lower end of the spectrum, CCCs could continue to rally if the current investor rotation into “value” factors persists, but we remain more focused on idiosyncratic credit risk drivers.

The author wishes to thank Katie Cheung for her contributions to this report.

 

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.

bullet bond is a debt instrument whose entire principal value is paid all at once on the maturity date, as opposed to amortizing the bond over its lifetime. Bullet bonds cannot be redeemed early by an issuer, which means they are non-callable.

Fallen angels are bonds that have been downgraded from investment grade to speculative grade status.

Negative convexity refers to the shape of a bond's yield curve and the extent to which a bond's price is sensitive to changing interest rates.

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).

Tail risk, sometimes called "fat tail risk," is the financial risk of an asset or portfolio of assets moving more than three standard deviations from its current price, below the risk of a normal distribution.  In a normal distribution, the area of left tail risk denotes the greater chance of a negative movement past three standard deviations. 

Whipsaw describes the movement of a security when, at a particular time, the security's price is moving in one direction but then quickly pivots to move in the opposite direction.

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. The ICE BofAML U.S. High Yield BB Index and the ICE BofAML U.S. High Yield CCC Index and the ICE BofAML US HY CCC & Lower Index are all components of the broad index.

The ICE BofAML US Fallen Angel High Yield Index is comprised of below investment grade corporate debt instruments denominated in U.S. dollars that were rated investment grade at the time of issuance.

ICE BofAML 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.

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.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, 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.

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.

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