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Market View

Previous instances in which high-yield spreads exceeded 800 basis points represented attractive entry points into the U.S. high-yield market.

While fans of U.S. football have been eying the projected margin of victory for the favored Carolina Panthers in Super Bowl 50, fixed-income investors have been avidly following changes in another spread—the yield difference between high-yield bonds versus U.S. Treasury bonds.

Investors’ appetite for riskier assets has diminished as a slowdown in global growth—paced by softness in China, the world’s second-biggest economy—sparked a sharp decline in commodity prices. Year to date through January 30, the Credit Suisse [CS] High Yield Index was down around 2%. (By comparison, the S&P 500® Index was down nearly 6%, and the Russell 2000® Index was lower by around 10%.) The yield on the CS High Yield Index reached more than 10% on January 20 (the highest level since 2011), before settling back down to 9.62% on January 29, still 42 basis points (bps) above where it started the year.

Initially, most of the pain was in commodity-related segments of high yield, especially bonds in the beleaguered energy sector. (Energy companies make up around 11% of the value of the CS High Yield Index, although this is down from around 17% in mid-2014, before the beginning of the crude oil slump.) Other non-commodity sectors that represent smaller weights in the index also have weakened in recent weeks.

The recent volatility has been reflected in high-yield spreads, which have expanded from 747 bps at the end of 2015 to 826 bps as of January 29; spreads reached as wide as 873 bps on January 20. (By comparison, the long-term median spread is 538 bps.) As Chart 1 shows, it is quite rare for spreads to reach levels above 800 bps. Spreads have breached this level only a handful of times in the past 30 years, and those episodes have tended to be fairly short-lived.  

 

Chart 1. High-Yield Spreads Rarely Have Been Higher
U.S. high-yield corporate bond spread over Treasuries, January 31, 1986–January 29, 2016

Source: Credit Suisse. Yield spreads represented by the Credit Suisse High Yield Index.
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 charts above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

In the January 11, 2016, Market View, we reminded investors that periods of negative returns in the high-yield market historically have provided attractive entry points. We noted that in the four previous years in which the Credit Suisse High Yield Index generated negative returns, the following three years historically generated solid returns.

But the recent widening of spreads gave us fresh impetus to examine the valuation question. What does history tell us about the performance of the high-yield market after episodes of spread widening, specifically those that eclipsed the 800 basis-point mark? Actually, the high-yield market historically has provided strong returns over the following one-, two-, three-, four-, and five-year periods. (See Chart 2.)

 

Chart 2. How Have Investors Fared after Spreads Exceed 800 Basis Points?
Average return on the Credit Suisse High Yield Index during indicated periods after spreads have reached 800 bps

Source: Morningstar. *As of January 31, 2016.
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. Instances of high double-digit returns were achieved primarily during favorable market conditions and may not be sustainable over time. The historical data shown in the charts above are for illustrative purposes only and do not represent any specific portfolio managed by Lord Abbett or any particular investment.

 

Take a look at the inset table in Chart 2, which shows the performance of the high-yield market during specific periods following dramatically widening spreads. In some cases, the market remained challenging, and there were negative returns over the next 12 months. But the overall average return is in the double digits. And looking farther out, returns have always been positive in the three to five years that have followed. The latest move above 800 bps in January 2016 may represent another attractive opportunity. [There is, however, no guarantee that the market will perform in a similar manner under similar conditions in the future.]

We also noted in the January 11 Market View that the negative annual return on high-yield bonds for 2015 is an anomaly for an asset class with a strong history; according to Credit Suisse, the high-yield market’s negative performance in 2015 was only its fifth annual loss in the past 28 years. Given this history, current spread levels may signal more favorable valuations for high-yield bonds.

Wider spreads and increased defaults remain a concern to many high-yield investors who have been concerned about the end of the current credit cycle, notes Zane Brown, Lord Abbett Partner and Fixed-Income Strategist. But these factors alone “do not assure the end of the credit cycle,” says Brown. In a recent column on lordabbett.com evaluating the status of the current credit cycle, Brown assessed four factors: U.S. economic growth, U.S. Federal Reserve policy, the maturity structure of high-yield bonds on the market, and a relatively conservative credit profile of new issues. His analysis suggested that aside from conditions specifically affecting energy and mining, crucial characteristics of the high-yield market “are not symptomatic of past credit cycles that were on the brink of more widespread defaults—and economic recession.”

To be sure, in 2016 the high-yield sector likely will have to contend with some credit concerns and additional periods of increased volatility. In such an environment, investors may wish to consider the potential merits of an actively managed portfolio. We previously have emphasized our belief in the advantages for an investment portfolio of rigorous, bottom-up fundamental credit research from seasoned professionals, coupled with a flexible, opportunistic approach to security selection. We believe the recent market volatility has created attractive valuations in certain segments of the high-yield market, where an experienced active manager can uncover opportunity.

 

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