Valentine’s Day is an apt reminder of the up-and-down relationship between high yield and oil over the past two years. It’s been all roses for the last 12 months as the asset class has rallied with oil since they both bottomed on February 11, 2016. Although we expect stability from high yield in 2017, its success over the last year limits potential future returns and makes a repeat of 2016 very unlikely.
The Odd Couple
Oil has rallied 105.8% since February 2016, powering high yield to a 25.9% return over the same period, based on the Bloomberg Barclays High-Yield Index, outperforming the broad Bloomberg Barclays Aggregate Bond Index by over 25%. On February 11, 2016, the price of oil bottomed at $26/barrel, leading the average spread of high yield over comparable Treasuries to increase to 8.4%, the widest level since 2011. That spread has decreased over the last year to 3.8% as of February 10, 2017, as defaults in the energy sector have largely come and gone. The current spread level is approaching the post-recession low of 3.2% hit during late-June 2014, when oil was trading at over $105/barrel [Figure 1].
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High Yield Spreads
An average spread of high-yield bonds to Treasuries below 4% has only been maintained for nine months post-financial crisis. This was essentially the first nine months of 2014, when oil traded at more than $90/barrel for all of that period and higher than $100/barrel for the majority of that time. Tighter spreads result in lower returns, as yield becomes the dominant driver of return (as we envision for 2017) and capital appreciation by way of spread tightening becomes less feasible. Spread levels have proven to be a useful indicator when forecasting future returns. The spread of high yield over comparable Treasuries is very correlated with the one-year future return of the asset class [Figure 2]. This matches intuition: spreads at high levels do not historically stay elevated for long, leading to spread tightening and capital appreciation, in addition to yield. Although we expect a modest return for high yield in 2017 (mid- to upper-single digits)*, a repeat of 2016 performance is almost impossible, given how tight spreads currently are.
*We expect the 10-year Treasury yield to end 2017 in its current range of 2.25 – 2.75%, with a potential for 3%. Scenario analysis based on this potential interest rate range and the duration of the index indicates low- to mid-single-digit returns for the Bloomberg Barclays Aggregate Bond Index.
Improving Default Picture
High-yield default rates declined steadily over the latter months of 2016, and the outlook for 2017 is even more encouraging. After ending 2016 at a 4.4% global high-yield default rate, rating agency forecasts for 2017 are near 3%. Continually improving prospects for the energy sector, signs of a pickup in economic activity, and a dearth of maturing bonds are all contributing factors. Other indicators also seem to support that optimism. The Federal Reserve Senior Loan Officer Survey (FSLO) has historically been a good leading indicator of defaults. The survey indicates whether banks are tightening or loosening lending standards for medium- and large-sized companies. This stands to reason: if companies can get a loan, they generally will not default. As the modified adage goes, “a rolling loan gathers no loss.” Although banks are still tightening their lending standards, they are barely doing so, and that net tightening has been decelerating to a near neutral reading of 1.4% as of January 31, 2017 [Figure 3]. This data point is solid confirmation of the default picture improving into 2017.
What’s Fair Value?
While we are cautiously optimistic on the outlook for high yield in 2017, given our expectation for stable to modestly improving spreads, much of the good news is likely priced into the market. Assuming the optimistic lower range of default forecasts for the coming year, in addition to the recent 35% average recovery rate for defaulted bonds, we would estimate the fair value of high-yield spread to be in the low- to mid-4% range, above the current 3.8% level as of February 10, 2017 [Figure 4]. The recovery rate is the percentage of par that a defaulted bond pays back to investors. The historical average is around 40%, but we are using a more conservative 35% rate here to account for lower than historical recovery rates over the last two years. This includes a 2.2% liquidity premium, which reflects the risk that a bond cannot be traded quickly without materially impacting the market price. A 2.2% liquidity premium reflects the long-term average yield in excess of the default rate that high-yield investors have demanded due to the lesser liquidity of the bonds.
Two important metrics when looking at credit quality for high-yield issuers are leverage and interest coverage. Leverage is the amount of debt the corporations have relative to assets, whereas interest coverage shows how many times a company can pay for its interest expense with its available earnings. Leverage is important because it gives investors a sense of the relative amount of debt corporations have, while interest coverage is important because it shows how big of a burden the interest payments of that debt are, especially important if financial hardships arise.
In today’s landscape, the two metrics are sending mixed messages to investors. Corporate leverage is certainly at high levels, as companies have taken advantage of historically low interest rates by increasing their debt significantly. Interest coverage has deteriorated somewhat but remains decent, due to the low interest rate environment in which many corporations have issued debt. In other words, corporations have high levels of debt relative to assets, but the interest expense is still manageable because the debt was issued at very low interest rates. Despite elevated corporate leverage, decent interest coverage ratios mean that the high debt levels will likely not be a problem for high-yield in 2017.
There are signs of marginal improvements in store for high yield in 2017: declining default forecasts, decent interest coverage, and improving business prospects amid an anticipated deregulatory and pro-business policy backdrop. These factors are largely priced into current spread levels already, however, the market may be on thin ice if equity markets become volatile. Bank loans have slowly become an increasingly attractive alternative as they now yield more than high yield and may benefit more in an environment of rising short-term interest rates. While both investment vehicles can be good income-producing options, we maintain our position of cautious optimism with high yield, and believe it can be used as a small complement to high-quality fixed income for suitable investors.
Article by LPL Research