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Market View

The sharp reversal in the high-yield market this year highlights the challenges of trying to time the market. Investors might want to consider the value of staying invested.

Investors had plenty to worry about at the start of 2016: uncertainty about the outlook for central bank policy, collapsing commodity prices, concerns about weak economic growth in the United States, and slowing global growth, particularly in China. The impact of these concerns was acutely felt in the high-yield bond market, especially given the asset class’s exposure to commodity-related issuers in the energy and metals and mining sectors.

Credit spreads in the representative benchmark, the BofA Merrill Lynch (BAML) U.S. High Yield Index, approached 900 basis points (bps) over Treasuries in early February, more than 500 bps wider than the lows reached in mid-2014. As we had pointed out earlier this year, there was a great deal of divergence of returns by credit rating and by sector, with ‘CCC’ rated names and commodity-related sectors suffering the brunt of the sell-off. This was the type of environment that created opportunities for active managers to take advantage of.

Then just when the outlook seemed the bleakest, the market had a sharp turnaround, beginning on February 11. Where do we stand today? High-yield bonds have been one of the best performing asset classes in 2016, with the BAML U.S. High Yield Index generating a year-to-date return of 12.5%, as of June 30. After a brief pullback at the end of June following the surprise “Brexit” vote from the United Kingdom, the high-yield market continued its recovery, with credit spreads reaching their year-to-date lows in mid-July. What has led the way? By credit rating (as illustrated in Chart 1), ‘CCC’ rated bonds have been the strongest segment of the market, rallying 23% year to date as of July 21.

 

Chart 1: ‘CCC’ Rated Bonds Led the High-Yield Market Year to Date
Year-to-date total return by category, as of July 21, 2016

U.S. High Yield Overall is represented by the BofA Merrill Lynch U.S. High Yield Master II Constrained Index. BB High Yield as represented by the BofA Merrill Lynch BB U.S. High Yield Master II Constrained Index. B High Yield as represented by the BofA Merrill Lynch Single B U.S. High Yield Master II Constrained Index. CCC High Yield as represented by the BofA Merrill Lynch CCC & Lower U.S. High Yield Master II Constrained Index.
Source: Morningstar.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. 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.

 

And the sectors that everyone wanted to avoid have been the best performers, with energy up more than 23% and the metals and mining sector roaring back with a 31.7% return.

 

Chart 2: High-Yield Sectors That Many Investors Avoided Have Been Outperforming So Far in 2016
Year-to-date performance by sector, as of July 21, 2016

Source: JP Morgan.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. 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.

 

These numbers become more interesting when you consider the default experience in these sectors. The great fear coming into the year was that the sharp decline in commodity prices would lead to an increase in defaults in these areas. And that is exactly what has happened. Defaults in the high-yield bond and loan markets have totaled nearly $44 billion in 2016, well ahead of the total in all of 2015, driving the default rate on high yield to a six-year high of 4.68%, according to JP Morgan. This has come predominantly in commodity-related names, with the energy and metals and mining sectors accounting for more than 80% of default activity. Excluding these sectors, high-yield defaults have remained near historical lows, at just 0.53%.

How can performance be so strong in the face of increasing defaults? This is not an unusual occurrence in high yield, since much of the pain typically is already reflected in bond valuations well ahead of the actual default. As we pointed out in January, these sectors were trading at extremely distressed levels, pricing in an increased level of defaults. Historically, as a market gains some clarity on who will survive (and who will not), strong recoveries can occur. An extreme example of this occurred during 2009.

As most investors recall, 2008 was the worst year on record for the high-yield bond market (and many other markets), with a steep decline of -26%. Default activity, however, was modest throughout most of the year. It was not until the following year that defaults peaked, with a double-digit default rate. In the midst of this huge increase in defaults, the high-yield bond market had its best year, with the BAML U.S. High Yield Index up 58.1% in 2009, as much of the pain had already been priced in, with extreme valuations in high yield after the sharp drop the prior year.

Investor sentiment toward high yield, however, can be somewhat bipolar, as illustrated by mutual fund flows into the high-yield bond category. For example, in the three months ended January 2016, the Lipper High Yield Bond category experienced more than $16.7 billion in outflows from high-yield bond mutual funds and exchange-traded funds. At the end of February, a few weeks after the market had bottomed, flows turned positive, and over the three months ended in April, the category took in more than $16.7 billion in inflows. After investors fled once again in May and June, flows have turned positive in July, with nearly $7 billion coming into the category through July 20.

Investors seem bent on making tactical calls on this asset class, looking to exit when conditions look bad and then returning once they feel the “all clear” signal has been sounded. A closer look at the long-term risk/reward profile of high yield suggests this may not be the best approach. As Chart 3 illustrates, over the past 25 years, high-yield bonds have generated returns that are competitive with the equity market, but with much less volatility, leading to more attractive risk-adjusted returns, as measured by the Sharpe ratio. In fact, high yield has delivered nearly 90% of the return of the S&P 500, with roughly half the volatility.

 

Chart 3: High-Yield Bonds Have Delivered Nearly 90% of the Return of the Equity Market, with about Half the Volatility Over a 25-year Period
(July 1991–June 2016)

Source: Credit Suisse. *High-yield bonds are represented by the Credit Suisse High Yield Index. **Stocks are represented by the S&P 500® Index.
Past performance is no guarantee of future results. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment. 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. 

 

Given this attractive performance profile, perhaps one should consider high yield as a permanent part of an asset allocation, rather than trying to make tactical moves of entering and exiting. There has been much written about the dangers of trying to time the equity market; perhaps a similar approach to high yield is warranted. 

But within a high-yield allocation, the performance divergence across sectors and credit ratings highlighted above illustrates, in our view, the need for an active approach to the asset class. Rigorous bottom-up credit research can help avoid those sectors and individual credits that are most at risk for credit deterioration. Meanwhile, by applying top-down macro insights, an experienced portfolio manager can tilt the portfolio toward favored sectors and adapt the overall risk profile to a position that is most appropriate for the given environment. A passive strategy would not have the benefits of such flexibility.

Investors often seem to focus on the potential risks of the asset class, while missing out on the potential benefits of investing in high-yield bonds. Clearly, investing in high-yield bonds increases the possibility of credit default relative to investment-grade bonds. But over the long term, the asset class boasts a very attractive risk-reward profile. In today’s world of negative interest rates and slow economic growth, high yield may provide investors with an attractive source of income and potential total return, with much less risk than the equity market. 

 

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