Reasons to Consider High Yield Bonds
Mandy Lui, Head of Wealth/Retail Distribution, Greater China & S.E. Asia, explains what drove the sell-off in the global high yield bond market, why default rates are likely to remain modest, and why now may be a particularly good time to consider the asset class.
What Has Caused the Significant Sell-Off in High Yield Markets This Year?
The first half of 2022 has been extremely volatile for most financial markets. In particular, in the global high yield bond market, the performance drag has been two fold. The first few months of the year saw bonds being adversely impacted by rising interest rate expectations, as central banks were forced into action to try and curb rapidly growing inflationary pressures—which were exacerbated by Russia’s invasion of Ukraine, among other factors. Over the past couple of months, we have also seen market sentiment increasingly worsen amid growing concerns of a recession, and this has resulted in sizeable outflows from the global high yield bond asset class.
Will High Yield Bond Default Rates Remain Low?
In our view, it is highly unlikely that defaults will reach levels that current credit spreads are beginning to imply, for a number of reasons. Despite the heightened macro-economic uncertainty, the underlying corporate and household sectors are starting from a very healthy fundamental position. Company earnings and cash flows, in many cases, have returned to or surpassed pre-pandemic levels. Companies have also raised record amounts of capital since the onset of the pandemic and have re-financed a lot of their near-term debt obligations. As a result, companies are sitting on ample cash balances. With less than 20% of outstanding high yield debt due over the next three years, companies have sufficient headroom to navigate the challenging environment.
Finally, relative to history, the credit quality of the market is significantly higher today, with 55% of the market having a BB rating.
Are Discounted High Yield Bond Prices a Sign of Distress or Opportunity?
The sell-off across global high yield bond markets has been both steep and broad-based. If we look at figure, the navy blue bar represents the percentage of the market trading at a discount of 15% or more. The green bar represents the percentage of the market trading at a spread level of 10% or higher, or what would typically be classified as distressed levels.
These measures have closely tracked each other over the long term, meaning that when the high yield bond market has traded at highly discounted levels in the past, it is been due to a higher proportion of bonds trading at very distressed levels. This has typically resulted in higher default rates, as we observed, for example, during the 2008 global financial crisis, or even more recently, during the 2020 Covid-19 shock.
Today, however, nearly half of the overall market is trading at significantly discounted levels, while only 11% of the overall market is trading at distressed levels. To add more context, nearly 45% of bonds trading at distressed levels are in fact rated BB, and hence have quite a strong credit rating profile.
As a result, given our expectations for default rates to remain modest—especially relative to the highly discounted levels at which bonds are trading—and with materially high yields on offer, we believe this presents a compelling backdrop for capital appreciation and total return opportunities.
Why Is This A Good Time To Invest In High Yield?
To provide some historical context, over the past 20 years, we’ve only seen the global high yield bond market drop to current levels on three previous occasions. On those occasions, the subsequent 12-month returns averaged 19%. At the same time, on those occasions, the global high yield bond index had a lower starting credit quality and a higher proportion of bonds trading at distressed levels.
Finally, it is worth noting that in these previous instances, the 12-month forward market recovery has been very uneven. Timing the market precisely can be extremely difficult. That is why we believe it is important to remain invested once the market rebounds, as previous inflection points have been fast and at times un-investable.