Reading Key Trends in U.S. High Yield | Lord Abbett
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Market View

Lord Abbett experts discuss important factors influencing the asset class—and their implications for investors.

Read time: 3 minutes

In a March 24 webinar with investors, “Taking a Flexible, Multi-Sector Approach to Long-Term Investing,” Lord Abbett Managing Director and Portfolio Manager Christopher Gizzo, Investment Strategist Riz Hussain, and Director of Product Strategy Stephen Hillebrecht discussed key aspects of the current fixed-income market, with a particular emphasis on important developments in the U.S. high yield bond sector. (This brief video features additional insights from Gizzo.) Here, we present selected highlights from their commentary.

  1. Signs of Strengthening U.S. High Yield Fundamentals

Overall, we are very positive on the U.S. high yield market. We have written about how spreads have fully recovered from the widest levels seen during the volatility last year. Clearly, the prospect of a strong U.S. “reopening” as COVID-19 vaccines are rolled out to hundreds of millions of Americans has boosted investor sentiment.

Indeed, the growth outlook augurs for a further strengthening of corporate balance sheets, and thus, issuer credit quality. That trend is evident in Figure 1. Although the COVID-19 crisis prompted a rise in the U.S. high yield bond default rate, the recent pace of defaults has been declining based on monthly default volume. There have been only five defaults in the past five months ending March 2021. For the trailing 12 months ended March 31, the U.S. high yield default rate declined from 6.1% to 4.8%, as the March 2020 experience rolled off the trailing 12-month period. That trend should continue as the large volume of defaults amid the global economic shutdown last April exits the trailing 12-month period.

As further evidence of improving credit fundamentals, the wave of credit ratings downgrades within U.S. high yield has reversed. Through the first 3 months of 2021, the volume of ratings upgrades ($153 billion par) has outpaced downgrades ($72 billion) by a ratio of 2:1.

 

Figure 1. Some Indications of a Top Building in the U.S. High Yield Default Rate

Source: J.P. Morgan. It is important to note that the high yield market may not perform in a similar manner under similar conditions in the future. LTM = last twelve months. 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. Past performance is not a reliable indicator or guarantee of future results.

 

With high yield issuer credit profiles continuing to improve, we think that the default rate that you see in the upper panel of Figure 1 could potentially fall below average and toward historic lows.

Indeed, we believe the default spike last year represented only a temporary reversal of a longer-term trend: the strengthening credit quality of the broad U.S. high yield market. Based on the credit quality breakdown of the ICE BofA U.S. High Yield Constrained Index, BB-rated high yield bonds composed 55% of the index as of the end of 2020, compared to 35% in 2000, and reached the highest level in the history of the index.

 

Figure 2. We’re Seeing the Highest Rated U.S. High Yield Market in History
Credit quality breakdown of the ICE BofA U.S. High Yield Constrained Index

Source: ICE BofA U.S. High Yield Constrained Index as of 12/31/2020 (most recent year-end). The BB-rated component of the index reached its highest level in its history in 2020. 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. Past performance is not a reliable indicator or guarantee of future results.

 

  1. “Fallen Angels” and “Rising Stars” Present Potential Opportunities

Speaking of credit quality, we’ve been getting a lot of questions about two specific types of bonds perched on the border of high yield and investment grade—“fallen angels” and “rising stars.” A fallen angel is a formerly investment-grade company that has been downgraded and thus has entered the high yield market. Conversely, a rising star is a high yield company that has been upgraded and crossed over into the investment-grade category.

The volume of fallen angels significantly increased in 2020 due to the COVID-19 crisis, encompassing some $238 billion of bonds. Record levels of formerly investment-grade companies entering the high yield market in 2020 contributed to the rise in the volume of BB-rated issues, and thus, added to the improved quality profile of the high yield bond universe mentioned above.

Why might it be important to focus on fallen angels? Former investment-grade names that are now part of the high yield bond universe historically have provided upside potential within the high yield bond sector, as these companies seek to regain their investment-grade status, as Figure 3 shows.

 

Figure 3. Fallen Angels Historically Have Provided Opportunity for Outperformance
Cumulative return difference between “fallen angels” (as defined) and entire BB-rated issue category for indicated periods

Source: ICE BofA US Fallen Angel High Yield Index and the ICE BofA BB US High Yield Constrained Index. Data as of March 31, 2021. T=0 is defined as the widest level in spread for each respective cycle: October 11, 2002; December 19, 2008, February 11, 2016 and March 23, 2020. 
Past performance is not a reliable indicator or guarantee of future results. Due to market volatility, the asset classes depicted in this chart may not perform in a similar manner in the future. For illustrated 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. Does not constitute a recommendation nor investment advice and should not be used as the basis for any investment decision.

 

One note on the 2020 cycle performance depicted in Figure 3: Fallen angels modestly underperformed from late February through mid-March largely due to the big move higher in interest rates that adversely impacted their longer-than-average duration capital structures. However, they did start to outperform again starting in mid-March as the pace of Treasury yield climbs slowed, and we believe the potential opportunity in this high yield category remains intact. 

What about the “rising stars”? We are starting to see early signs of a significant number of issuers moving to rising star status. In January 2021, the volume and number of high yield bonds put on positive watch by ratings agencies started to rise. During the economic shutdown last year, many market observers estimated large waves of defaults. Many of those projections were too pessimistic, and we have seen default expectations come down, and ratings downgrades start to turn into upgrades.

We think there’s some strong rising-star potential among companies that originally came to market as high yield companies and have matured into investment-grade capital structures, as well as those which were knocked down for fallen angel status, courtesy of the pandemic, but may be back on the road to investment grade as their operational and financial health improve during the economic recovery.

A Final Word
The trends we’ve noted above may have significant implications for those investors seeking higher income in current the low-rate environment. One potential approach involves a professionally managed portfolio of high yield securities selected using rigorous credit research and a disciplined approach to identifying relative value. For those who would like to maintain exposure to high yield but with a lower degree of potential investment risk, a multi-sector approach emphasizing strategic allocations to high- yield and investment-grade credits may prove appealing. Multi-sector bond strategies can offer access to opportunities across many segments of the credit markets, with the flexibility to rotate to areas of the market that present the best relative value. As the economic environment changes, multi-sector strategies offer the flexibility to adjust exposures accordingly.

A diversified approach such as this can provide higher income and total return potential than core bonds, with lower volatility than dedicated high yield strategies. Lord Abbett’s multi-sector investing discipline recently marked its 50th anniversary, and has a long track record of delivering income and total return to investors through five decades of widely varying economic and market environments.

 

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 commentary 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.

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.

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

Rising stars refers to high-yield bonds that have been upgraded and crossed over into the investment-grade category.

The ICE BofA U.S. High Yield Index is a capitalization-weighted index of all U.S. dollar-denominated, below-investment- grade, corporate debt publicly issued in the U.S. domestic market. The ICE BofA U.S. Fallen Angel High Yield Index (bonds downgraded from investment grade to speculative grade) is a subset of the ICE BofA U.S. High Yield Index.

The ICE BofA U.S. High Yield Constrained Index is a rules-based index consisting of U.S. dollar-denominated, high- yield, corporate bonds for sale in the U.S. The index is designed to provide a broad representation of the U.S. dollar-denominated, high-yield, corporate bond market. The index is a modified market value-weighted index with a cap on each issuer of 2%. The ICE BofA BB US High Yield Constrained Index is a ratings-specific subset of the ICE BofA U.S. High Yield Constrained Index.

ICE BofA Index Information:

Source: ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofA 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 BofA 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.

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 is 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 principal on these securities.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.  If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this commentary 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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