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May 23, 2013 at 09:37 PM
One of the really bright spots in the investment universe over the last few years has been the high-yield bond market.
Since rates began falling in the wake of the 2008 financial crisis, global demand for higher-yielding assets has been steadily rising. This demand has outstripped supply to drive prices higher and yields lower. At this point, after four years of a bull market in the asset class, it’s reasonable to ask if high-yield bond buyers are still being adequately rewarded for their investment risk. Based on a review of key statistical data, along with our conversations with key bond market players, we’re willing to suggest they are, at least to a degree. Here’s why we think signs point to a marginally positive outlook for the broader non-investment grade asset class.
Measured Risk
From a fundamental perspective, the financial strength of issuing companies within the U.S. high-yield market remains fairly strong. Strong enough, in fact, that the 12-month rolling default rate in the high-yield market has remained around a historically low 2% since 2008. Not surprisingly, issuers in the space have taken advantage of their solid balance sheets to refinance pre-2008 debt at today’s significantly lower rates. This debt restructuring is somewhat of a double-edged sword for investors, of course, in that the lower annual debt service decreases the likelihood of default but at the same time results in smaller coupon payments.
In the meantime, low levels of merger and acquisition activity have been supportive of these quality fundamentals. In general, M&A activity creates additional bond supply but it means shakier balance sheets as well. Interestingly, despite high levels of anticipation, deal levels remain historically low.
Measurable Reward
So given its reasonably strong fundamentals, what is the relative value of the high-yield market versus its investment-grade competition? The answer is positive but mixed. The chart below shows the Barclays U.S. Corporate High Yield Index’s option adjusted spread (OAS) over similar maturity Treasuries and yield-to-worst (YTW) over the past two decades. An examination of the chart shows that the high-yield OAS has fallen from a whopping 1,800 basis points at the height of the 2008 crisis to just over 450 basis points today, very near the median level of spreads over the last 20 years. Since spreads over Treasuries have moved and remained lower for years at a time, it can be inferred there is some room for further spread compression and capital gains for high yields going forward.
