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December 14, 2015

High-Yield bond sell-off is no buying opportunity

2015 is shaping up as potentially the worst non-recession year for high-yield bonds. The US High-Yield market is down 7% YTD and Europe is not faring much better with -3%. The heavy redemptions, rock-bottom levels of risk tolerance and persistent downside risk for oil prices will likely continue to weigh on High Yield. We reiterate our preference for investment grade bonds over high yield bonds. In this market comment, we analyze what triggered the sell-off and what our view is on credit going into 2016.

2015 worst year since the financial crisis in 2008

Baring a rebound in the remaining days of December, 2015 would be the first negative return-year for US High-Yield bonds outside of recession years. As can be seen in the following chart, US High-Yield bond spreads have been widening since mid-last year

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The poor performance of the High-Yield market recently should not have come as a surprise. We have repeatedly written that the fundamentals are looking shaky and that valuation is more than stretched:

  • June 2015 – “In our opinion, this yield pick-up is not enough to include high-yield bonds in a portfolio for long-term holders” and “Today… high-yield bonds are an unattractive investment.”
  • April 2014 – “Why high-yield bonds should no longer be on your buy-list”

What triggered the sell-off?

We see four main reasons for the underperformance of high-yield bonds relative to equities:

  1. Large concentration in commodity exposed sectors has contributed to HY losses. The price for oil and other commodities has declined rapidly this year, thus putting pressure on the financial health of many HY issuers. The energy and materials sector accounts for nearly 20% of the US HY market while it is only 9% in the S&P 500.
  2. US corporate credit quality has deteriorated to the weakest level in a decade. Ex-financials, the median leverage ratio (net debt/EBITDA) is at the highest level in more than a decade. Corporate balance sheets are increasingly looking unhealthy. Yes, interest coverage still looks ok, but that could be temporary if we really enter a sustained rate-rise cycle
  3. Jump in the projected default rate. While the 2015 US HY default rate will probably end around 3%, the consensus forecasts are looking for the default rate to double in 2016.
  4. Poor liquidity in credit markets is exacerbating the price moves. Equities do not suffer from the same liquidity issues.

While these are all important catalysts, investors should not forget that the valuation was more than stretched to begin with. In a zero interest rate environment, investors chased yield and drove high-yield spreads to unsustainable levels. In many respects, high yield was a bug in search of a windshield. It did not really matter what the final catalyst was, high yield was an accident waiting to happen in our view.

Have we reached bottom and should investors start buying High Yield?

As we wrote before: “success in investing is not a function of what you buy. It is a function of what you pay”. Right now, the price is still not attractive.

We prefer the rate risk of US investment grade bonds to the oil, default and liquidity risk of US high yield bonds. However, we also prefer EU credit over US credit due to the different monetary policy, better sector composition and higher credit quality over here.

Summary: “All roads to hell are paved with positive carry”

Low interest rates of the central banks have forced investors out on the risk curve in order to reach for yield. But in the current environment, it is useful to recall the Ray DaVoe quote: “More money has been lost reaching for yield than at the point of a gun”. I can give you whatever yield you like, if you don’t care about preservation of capital. Yield is the oldest scam in the book. If you don’t understand the risks you are taking to reach that yield, don’t invest there.

If you are looking for more practical advice, maybe the following rules of thumb can help with your investments:

  • Historically, it was a good time to invest in credit (investment-grade), when the spread was >200bps over treasuries. We are currently still only around 150.
  • High-Yield should at most be 5% of your portfolio, if at all.