U.S. High Yield: Navigating Through the Volatility

Lord Abbett experts assess the challenges—and opportunities—they’re finding in today’s U.S. high yield market. 

In Brief

• Amid volatility engendered by the uncertainty of the economic impact of the Covid-19 virus, U.S. high yield spreads recently widened significantly, while yields reached multi-year highs.
• But periods of elevated spreads historically have not lasted for long, and since 1987 investors typically have realized positive returns in the 12, 24, and 36 months following instances when spreads exceeded 900 basis points.
• While we expect increased defaults, and ratings downgrades within high yield, it’s worth noting that the overall credit quality of the high yield market has strengthened since the 2008-09 financial crisis.
• During the late-March rally in high yield, Lord Abbett’s investment team opportunistically added risk to the portfolio. Overall, the team is emphasizing the higher ratings tiers in the high yield category--‘BB’- and ‘B’-rated securities.

Amid the ongoing market volatility, Lord Abbett investment professionals have stayed in close contact with advisors and investors to provide timely perspective on recent events and their impact on portfolios. On March 26, Lord Abbett Partner and Director of Taxable Fixed Income Steven Rocco and Director of Product Strategy Stephen Hillebrecht held a webinar for professional investors on developments in the U.S. high yield market. Here, we summarize our experts’ views through their answers to investor questions.

Please give us a brief overview of what’s influencing the U.S. high yield market.

Steven Rocco: I believe these last four weeks have truly been unprecedented in my career in asset management. On the macro level, the Covid-19 pandemic really is a health crisis that became an economic crisis that is now a financial crisis. Last week [of March 16] was certainly very tumultuous for the high yield market, but coming into this week [of March 23], we were looking for three things to become more constructive. One is a “big bang” monetary policy response. Two, a large U.S. fiscal bill, and three, and I think this is the most important, some signs of victories on the health side.

So I would say we got the first two things, and the market has responded quite nicely in the past few days, but they won't solve the problem. We need some victories on the health side. So what we're looking for moving forward is a flattening of the infection curve to give people hope that governments’ quarantine strategies are working. I think we will see that pretty soon.  Progress in treatments—and ultimately, a vaccine—for the virus would, I think, provide some hope for the market. But the question will be one of timing—how quickly you can flatten the infection curve, start lifting quarantines, and get the U.S. economy running again.

As I noted, high yield has had a very strong rally in the past few days, with the telecom, healthcare and cable sectors being strong outperformers. That said, in high yield we also have the energy sector, which was already underperforming before the big price declines in crude. And we don't expect any sort of miracle for some of those energy credits.

What about credit quality considerations?

Rocco: The U.S. high yield market has priced in default rates of greater than 40%. (Read a recent commentary on market expectations of default rates.) We've also seen a lot of “fallen angels”—companies who have moved from investment grade to below investment grade due to rating changes—in the last three weeks. I wouldn't say that's a negative technical factor for the market given everything else that’s going on at the moment, but it's something that needs to be watched.

And we believe there probably will be more downgrades to and within high yield, but it’s worth noting that the U.S. high yield market entered this period of volatility in very good shape from a credit quality perspective, in our view.

Stephen Hillebrecht: In the last crisis, going back to 2007 (as of June 30), you had a high yield market that was over 20% triple C—that level has come down to only 13% today. And the highest ratings tier of below investment grade, BB, now accounts for nearly half the index, versus 36% in 2007. While that might be changing a little bit given recent downgrades, and the entry of “fallen angels” into the BB category, recent overall credit quality in U.S. high yield was much better than where we were coming into the 2008 crisis.

Talk about the team’s current investment approach to U.S. high yield.

Rocco: What have we been doing? We've actually taken credit risk up in our strategies. And so we were aggressively buying risk on Friday, March 20 and Monday, March 23. More broadly, we are looking at ‘BB’- and ‘B’-rated issues—the less risky types of allocations. Previously, over the last few months we've increased allocations to BB and reduced some ‘CCC’-rated issues.

We are confident that we're going to see the other side of this. To be sure, we think there will be winners and losers, including some companies that won't be able to survive this period. We're trying to get a handle on which companies those might be. We're not trying to predict the bottom. But I think while we see how this all sorts out we are being “paid to wait” at current yield levels.

What about recent moves in high yield spreads?

Stephen Hillebrecht:  We have a chart that we think tells a compelling story. In January, spreads were under 350 basis points (bps). With this recent volatility that has been seen across markets, high yield spreads were recently approaching 1100 bps, a move of more than 700 bps. While that has come back some in recent days, you are still looking at levels you haven't seen since 2008.

Chart 1. U.S High Yield Spreads Have Rarely Exceeded 1,000 Basis Points
U.S. high yield spreads, February 28, 1998-March 23, 2020
 

Source: ICE Data Indices, LLC. Data as of March 23, 2020. 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%.

And yields?

Hillebrecht: If you look at yields, it’s a very similar situation. Take a look at this chart based on the benchmark ICE BofA U.S. High Yield index. At 11.4% on March 23, the yield on the index was well above the historical median. In fact, reviewing month-end data going back to 1998, yields have been above  11% only about 20% of the time. It's rare that you get yields at this level.

Chart 2. Yields on U.S. High Yield Recently Reached Multi-Year Highs
Average yield on the ICE BofA U.S. High Yield Index, December 31, 1994-March 23, 2020

Source: ICE Data Indices, LLC. Data as of March 23, 2020. YTW=Yield-to-worst.
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.

Another question about spreads—what has been the investment experience after other instances of elevated spreads?

Hillebrecht: We think this table helps tell the story. Going back more than 30 years there've been 25 months that the spread on the JP Morgan U.S. High Yield Index ended the month above 900 basis points.

Table 1. High Yield Index Returns after Spreads Reach 900 Basis Points

Source: JP Morgan US High Yield Index.  Table shows performance of the Index in the following months that the index average spread was greater than 900 basis points, based on 25 observed instances since the index inception in 1987.  Data as of 3/23/2020.
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.

What you see here is that in all 25 months, one year later you had positive returns. On average you were looking at returns of 20 to 35% over the next one to three years. Now in many cases, spreads widen further after reaching 900 bps, and there might be some short term mark-to-market pain. But if you have a longer investment horizon—two-to-three years or more—historically, these levels generally have offered you a pretty good entry point.

Rocco: It's unsettling when you have spreads go from 400 bps to almost 1100 bps in the course of a couple of weeks. However, what that has done is created valuations that are pretty compelling and opportunities that you haven't seen too often except for prior crises. Of course, it's very difficult to call the bottom. But for those with time horizons looking out 12, 24, 36 months, valuations for high yield are such that investors may want to take a closer look.

Any final thoughts?

Rocco: Don't underestimate the ability of the United States to reach the right answer and the right solutions to the Covid-19 situation. I believe eventually this is something that we'll all learn to live with and protect ourselves from, and life will go on. Nobody knows what the next month or three months will look like. But if you look out a year or two or three years, we believe it’s likely that things will look a lot better.