Ben Inker of Grantham, Mayo, Van Otterloo & Co. begins his latest fixed-income outlook on a somber note, pointing out that the Barclays U.S. Corporate High Yield index fell 4.5% in 2015 with a coupon of about 6% and duration of less than five years. Translation? The average high-yield bond had about 200 basis points of spread widening.
Recent spreads, according to the head of asset allocation for GMO, an investment management firm, are much wider than their long-term averages. And this prompts some analysts to ask if high-yield debt is cheap these days.
“There is no particularly easy answer to this question given the nature of high yield, but the short answer is ‘probably,’ with a strong suspicion that it is not worse than fair value,” explained Inker. “In an environment where very few assets around the world are even particularly close to fair value, that statement seems like a pretty strong endorsement.”
He said GMO was a “steady” buyer of some high yield names for its Benchmark-Free Allocation Strategy (BFAS), considering that default rates “were likely to rise over the next few years. Our careful approach was rewarded, as our portfolios of high-yield and distressed assets in BFAS made decent money in a down year for the asset class, and our holdings of structured debt also made money on the year.”
At least for the short term, this strategy remains constant in 2016.
“We are continuing to increase our holdings of high-yield and distressed assets and expect to keep buying over the next several months as long as spreads stay near current levels or continue to widen. We are not yet leaping into high yield with both feet, however, for a couple of reasons,” Inker explained.
New Default Cycle
The GMO team, like some major fixed income players, says the economy seems to be entering a new “default cycle” in which default rates on high-yield bonds rise above their long-term averages. Furthermore, the high yield market is indicating that it may “overshoot fair value as defaults rise,” Inker says.
The long-term average default rate has been roughly 4.6% since 1988, but that has included annual rates that topped 15% and fell below 1%.
“A yield spread over Treasuries that would give wonderful returns at a 1% default rate would leave you crying over your brokerage statements if we saw 15% instead,” he explained. While in calm times, default rates are about 2% to 2.5%, they hit 14% in 2008-2009 and 26% in 1998 to 2003.
Inker and his colleagues view bonds as moving into “default cycle four.” They caution that investors should be ready for defaults to rise — not only in the energy and mining sectors.
How bad will the cycle be? Energy and mining sectors “are clearly in for a very rough time of it,” says Inker. Plus, the early defaults from this wave in 2015 “saw some shockingly low recovery rates on the bonds — single-digit or zero recoveries in several cases against long-term average recoveries for senior unsecured debt of a little over 40%.
Reflecting on recent history, Inker notes that default rates do not have to be very closely coupled to economic growth. Also, the 1998 to 2003 period was “almost certainly not a true ‘worst-case scenario,’” he wrote.
At current yields, high yield “is a real bargain if we actually experienced ‘calm time’ defaults over the next five years, and is still quite cheap if we see default rates that track the long-term average,” Inker states.
Bad News, Good News
High yield is not guaranteed to have a good outcome from here, the GMO asset allocator says, “but the likely results over the next five years range from just about acceptable to wonderful in anything but the most dire default scenario.”
Why not jump into high-yield bonds?
Default losses are not the equivalent of an equity drawdown, according to Inker. Rather, they are “a permanent impairment of equity value.”
Plus, it looks like this market could have “a hard time stopping at fair value on the downside,” he adds. Furthermore, during a default cycle, the frequencies of bonds being downgraded to junk status can double or more. Perfect Timing?
Inker summaries his views as follows: “At current spreads, high yield seems to be no worse than fair value and probably better than that, even if we assume (as we do) that we are entering a fourth default cycle. In today’s environment, that makes it one of the best available risk assets for investors.”
The nature of the high-yield market, however, suggests it may overshoot fair value on the downside whenever defaults begin to rise in earnest.
“Our response for BFAS at current levels is to continue to search for credit securities offering a superior combination of expected returns and downside protection while augmenting this at the margin with more index-like credit exposure,” he explained.
The GMO team knows it can’t perfectly time the bottom.
“This leaves us with the hunch we are probably getting in a little early, the fear that we might not get all the exposure we would like before spreads move to less attractive levels, and the sure knowledge we won’t get the bragging rights of having called the turn,” Inker concluded. “In other words, it seems to be an utterly classic value investing opportunity.”
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