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Fixed Income

Are High Yield Investors Being Compensated for Risks?

2019 October - 3 min read

In the context of today’s fundamental backdrop and default outlook, spread levels suggest investors are being fairly compensated, relative to other points in the cycle, for the amount of risk they are taking.

While the search for yield is nothing new, it has certainly intensified in recent months as low, and even negative-yielding debt continues to dominate the investment landscape. But for investors who may normally turn to higher-yielding assets, such as high yield bonds and loans, a number of potential concerns—slowing economic growth, the elongated credit cycle, and an increase in defaults—remain top of mind.

One big question, in particular, is around valuations—and whether spreads, at current levels, are compensating investors for the amount of default risk they’re assuming. The short answer, in our view, is yes—based on a few key considerations: 

  1. Market and issuer fundamentals 
  2. Supply/demand dynamics 
  3. Historical default and recovery rates 

Market & Issuer Health

Broadly speaking, high yield issuers appear to be more disciplined compared to the years preceding the global financial crisis. Looking at U.S. high yield bonds, for instance, the volume of leveraged buyouts—higher-risk deals that involve a significant amount of borrowed money—is lower today versus 2006/2007.1 In addition, CCC bond issuance has been somewhat muted relative to the years leading up to the financial crisis. Issuance of higher-risk payment-in-kind or deferred bonds has also been lower, accounting for less than 1% of total issuance in recent years.1

RECENT U.S. ISSUANCE TRENDS ARE HEALTHIER COMPARED TO 2006/2007Recent U.S. Insurance Trends are Healthier Compared to 2006/2007

Source: J.P. Morgan. As of February 2019. Lower rated is defined as credits rated Split B, CCC or NOT RATED.

Driven by a reasonably strong economic backdrop over the past few years, corporate earnings have been solid and leverage levels largely stable. Additionally, due in part to lower financing costs over the last decade, interest coverage ratios appear relatively healthy.

As a result, defaults—the biggest potential risk for high yield investors—continue to hover around 3%, slightly below long-term historical averages.2 While an increase in defaults across more challenged sectors—energy and retail, namely—has contributed to a slight uptick in overall defaults this year, we do not expect to see a widespread or material increase in defaults in the near term.

U.S. HIGH YIELD HISTORICAL DEFAULT RATEU.S. HIGH YIELD HISTORICAL DEFAULT RATE

Source: Credit Suisse. As of August 30, 2019. 

From a technical standpoint, we believe the high yield market overall remains supported. Demand is steady, coming from both the re-investment of existing capital and new capital entering the asset class. Given the ongoing search for yield, we believe demand should remain healthy, and with the relatively muted forward calendar, the market should be well-supported going forward.

That said, economic cycles by nature have an end date, and we will eventually go through another recession. And while we don’t expect the next downturn to be as severe as the financial crisis—based on the generally more conservative financial profiles of high yield issuers today—we would certainly anticipate an increase in defaults through the next cycle.

Spreads in the Context of Defaults

While defaults do entail a potential loss of principal, there are typically opportunities to recover a portion of that through a restructuring process. Although past recovery rates do not indicate future results, factoring in long-term recovery assumptions for various high yield assets—from senior secured loans and bonds to unsecured bonds—can provide a general idea of what the implied default rate should be based on the current spread levels across various recovery assumptions.

For example: High yield bonds are currently offering spreads of roughly 400 basis points (bps) over the risk-free rate.3 If an investor assumes a recovery rate of 50% for high yield bonds—very close to the long-term average recovery rate for senior unsecured high yield bonds4—a spread of 400 bps would imply an 8% default rate in order to fully erase any excess spread that should be required over a risk-free opportunity. For context, the last time U.S. high yield bond defaults reached 8% was during the financial crisis. Even assuming a 30% recovery rate—significantly lower than the long-term average for senior unsecured high yield bonds—a spread of 400 bps would imply a 5%–6% default rate in order to fully erase excess spread, a rate not seen since 2008/2009. This scenario appears overly pessimistic given the current state of the economy and previously mentioned fundamental backdrop.

Of note, these assumptions do not fully capture potential trading volatility in the asset class during periods of economic weakness, but they do help frame the relative level of risk premium in the market for long-term, strategic investors. Every investor is different, and risk/reward thresholds can vary significantly. As such, while these assumptions are no guarantee of future results, they can enable investors to identify—based on their own assumptions and future expectations—whether current spread levels look attractive in light of the risks they expect to encounter going forward.

LOSS GIVEN DEFAULT SCENARIOSCHART TITLE

Source: Barings. Loss Given Default calculated as the default rate multiplied by one minus the recovery rate. For illustrative purposes only. PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE RESULTS.

Poised to Capture Relative Value

In today’s uncertain environment, we think a bottom-up, credit-intensive approach is key. While we believe the markets look fairly stable from a fundamental standpoint, there are a number of potential risks—escalating trade tensions, ongoing Brexit negotiations, concerns around commodity pricing—that could impact high yield going forward. Concerns surrounding slowing global economic growth and the possibility of a recession also linger.

Rather than trying to time investment decisions around these factors, we see value in taking a rigorous, bottom-up approach to credit selection, aiming to choose credits that can withstand headwinds and hold up through cycles. An active approach can be particularly advantageous, as it can allow managers to move away from credits that exhibit fundamental weakness in favor of healthier issuers. If or when defaults do increase, investors can benefit from partnering with managers who have a long track record of handling these situations. Managers with deep resources and an experienced team are very well-positioned, in our view, to manage high yield assets through market volatility and drive attractive risk-adjusted returns.

1. Source: J.P. Morgan. As of February 2019.
2. Source: Credit Suisse. As of August 30, 2019.
3. Source: Bank of America Merrill Lynch. As of August 30, 2019.
4. Source: Moody’s Corporate Default & Recovery Rates. As of February 2019.

  • David Mihalick
    David Mihalick

    Head of U.S. Public Fixed Income & Head of U.S. High Yield

The document is for informational purposes only and is not an offer or solicitation for the purchase or sale of any financial instrument or service.  The material herein was prepared without any consideration of the investment objectives, financial situation or particular needs of anyone who may receive it. This document is not, and must not be treated as, investment advice, investment recommendations, or investment research.

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In making an investment decision, prospective investors must rely on their own examination of the merits and risks involved and before making any investment decision, it is recommended that prospective investors seek independent investment, legal, tax, accounting or other professional advice as appropriate.

Unless otherwise mentioned, the views contained in this document are those of Barings. These views are made in good faith in relation to the facts known at the time of preparation and are subject to change without notice.  Parts of this document may be based on information received from sources we believe to be reliable. Although every effort is taken to ensure that the information contained in this document is accurate, Barings makes no representation or warranty, express or implied, regarding the accuracy, completeness or adequacy of the information.

Any forecasts in this document are based upon Barings opinion of the market at the date of preparation and are subject to change without notice, dependent upon many factors. Any prediction, projection or forecast is not necessarily indicative of the future or likely performance. Any investment results, portfolio compositions and/or examples set forth in this document are provided for illustrative purposes only and are not indicative of any future investment results, future portfolio composition or investments.  The composition, size of, and risks associated with an investment may differ substantially from any examples set forth in this document.  No representation is made that an investment will be profitable or will not incur losses. Where appropriate, changes in the currency exchange rates may affect the value of investments.

Investment involves risks. Past performance is not a guide to future performance. Investors should not only base on this document alone to make investment decision. 

This document is issued by Baring Asset Management (Asia) Limited.  It has not been reviewed by the Securities and Futures Commission of Hong Kong.

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