The return of yield to the high yield market

Transcription

1 FOR INSTITUTIONAL/WHOLESALE/PROFESSIONAL CLIENTS AND QUALIFIED INVESTORS ONLY NOT FOR RETAIL USE OR DISTRIBUTION The return of yield to the high yield market High yield credit November 215 AUTHORS IN BRIEF As market participants worry about global growth, high yield bonds have come under pressure along with other risk assets. Yields are the highest they have been since the eurozone crisis of 211, and spreads have widened well above their long-term average. Price declines initially hit energy- and commodity-related issuers but subsequently moved to many other sectors. Yield and opportunity have returned to the high yield market. High yield issuers are mainly exposed to developed markets, and prospects are relatively good for developed markets economic growth. As we approach a Federal Reserve (Fed) tightening cycle, we do not expect a U.S. recession in the near term. We are in the middle stage of the credit cycle. Economic conditions have not been sufficiently robust to encourage aggressive behavior on the part of either investors or issuers. Issuer restraint can be seen in default rates well below their long-term average. Investors should not fear a rate hiking cycle. Spreads typically do not widen substantially until well after the end of the cycle, when credit conditions are tighter. David Seaman Managing Director, Client Portfolio Manager, High Yield, Global Fixed Income, Currency & Commodities Group, J.P. Morgan Asset Management Joshua McGee Executive Director, Client Portfolio Manager, High Yield, Global Fixed Income, Currency & Commodities Group, J.P. Morgan Asset Management Concerns about global growth, led by continued uncertainty over the severity of the slowdown in China, have pressured risk assets. The possibility of negative returns for all risk assets has increased dramatically over the last few months; risk has re-priced. Unsurprisingly, the high yield market has not been immune. Between June 1 and September 3, 215, high yield bonds posted four consecutive months of negative returns, for the first time in over 2 years. Yields rose above 8.%, the highest they have been since the eurozone crisis in the fourth quarter of 211; spreads over Treasuries moved to around 66 basis points (bps), 1 about 6% wider than they were a year ago and above their long-term average of 575bps. Price declines first hit energy and commodity-related sectors, but recently many other sectors have felt the sting. To put it plainly, yield has returned to the high yield market. October has proved to be kinder to the high yield market, returning 2.73% month to date through October 28, 215. Looking past the daily market ups and downs, we believe the current environment presents an attractive opportunity for fixed income investors. In the following pages, we explain why yields have recently risen and spreads widened; assess the market s economic fundamentals and valuation metrics; and consider the outlook for high yield in a rate hiking cycle. 1 Throughout this paper, statistical references to high yield bonds are sourced from the Bank of America Merrill Lynch US High Yield Master II Constrained Index.

2 MARKET SNAPSHOT During the earlier years of the high yield market, the 198s and 199s, issuers of below-investment grade debt were generally smaller, private companies with limited financial reporting requirements; secondary market information and activity were opaque. Today s high yield market is quite different. (In this paper, we examine the universe of developed markets high yield debt; emerging markets debt is beyond the scope of this analysis.) The developed markets high yield universe is a USD 1.3 trillion market, with 1,1 unique issuers, 4 distinct industries and an average issue size of $6 million. Issuers have risk exposure to countries that are members of the G1 and Western Europe; 83% of issuers are domiciled in the U.S. Many are public companies with market-leading positions in their respective lines of business. Recently, market participants have focused on potential strains on bond market liquidity. Some worry especially about retail outflows, after years in which retail investors moved substantial assets into high yield bond funds ($15 billion between January 1, 26, and December 31, 212). Between February and August, Lipper reports, $19 billion exited high yield bond mutual funds, but in late October the tide shifted somewhat, with a nearrecord $3.3 billion of high yield inflows in the week of October 23. As we consider bond market liquidity, we note that the high yield market has never been more transparent. All secondary trades, whether 144A or publicly registered, are now posted on the NASD Trade Reporting and Compliance Engine (TRACE) reporting system. An average of over $1 billion of high yield volume trades every day. High yield bonds today represent a critical component of global capital markets and an important element in a diversified fixed income portfolio. THE CASE FOR HIGH YIELD: ECONOMICS The case for high yield begins with economic fundamentals (EXHIBIT 1). High yield issuers do have cash flow exposure to emerging markets, primarily in the energy- and commoditysensitive sectors, but broadly speaking, cash flows are dominated by developed markets, where prospects for Prospects for economic growth look relatively good across most developed markets EXHIBIT 1: GLOBAL PURCHASING MANAGERS INDEX FOR MANUFACTURING Global Developed markets Emerging markets U.S Canada UK Euro area Germany France Italy Spain Greece Ireland Australia Japan China Indonesia Korea Taiwan India Brazil Mexico Russia Oct-13 Nov-13 Dec-13 Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Jan-15 Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15 Aug-15 Sep-15 Source: Markit, J.P. Morgan Asset Management Guide to the Markets; U.S. data are as of September 3, 215. Heat map colors are based on PMI relative to the 5 level, which indicates acceleration or deceleration of the sector, for the time period shown. 2 THE RETURN OF YIELD TO THE HIGH YIELD MARKET

3 economic growth are relatively good. Looking at the world s biggest developed market, the U.S., as we approach a Fed tightening cycle, we do not expect a U.S. recession in the near term. That is an important point: While negative return years in the high yield market are rare, appearing only five times in the last 29 years, they have most often occurred during U.S. recessions (1991, 21 and 28). WHERE ARE WE IN THE CREDIT CYCLE? Each stage of a business cycle carries a distinct set of economic and credit market characteristics. The current cycle began after the credit crisis of 28, and many investors are questioning if we have entered the late stage and can therefore anticipate a broader weakening of credit fundamentals. We believe we are in the middle stage of the credit cycle. Traditionally in late-stage credit cycles, we have experienced above-trend economic output, aggressive consumption, high levels of capital investment and high wage inflation, which have led to overly aggressive, optimistic issuer and investor behavior. In the current environment, on the other hand, U.S. economic data has shown modest economic output, restrained consumption, relatively low capital investment and little wage inflation, leading to issuer and investor discipline. Economic conditions have not been sufficiently robust to encourage widespread aggressive behavior on the part of either investors or issuers. Issuer restraint can be seen in modest default rates: The trailing 12-month default rate (par-weighted) of 2.29% is well below the long-term average of 3.99%. It is worth noting, too, that 75% of all defaults in the high yield market over the last 12 months have been in two sectors, energy and basic materials. Lower-rated issuance has declined, companies have reduced capital expenditures (capex), leverage remains reasonable, and interest coverage ratios are very strong. In another sign of mid-cycle behavior, market participants are demanding higher yields for acquisition-related deals of any significant size. For example, discerning investors significantly repriced recent deal-related issues by Altice/Cablevision and Frontier Communications, and that repricing in turn re-priced the cable and wireline telecom markets materially wider (EXHIBIT 2). Issuers and investors remain relatively disciplined EXHIBIT 2A: NEW-ISSUE VOLUME USD (billions) YTD 15 YTD 14 EXHIBIT 2B: HIGH YIELD USE OF PROCEEDS Refinancing-related issuance Acquisition financing-related issuance YTD 15 YTD 14 EXHIBIT 2C: LOWER-RATED HIGH YIELD ACTIVITY* YTD 15 YTD EXHIBIT 2D: AGGRESSIVE HIGH YIELD ISSUANCE Lower-rated, nonrefinancing issuance Wireline telecommunications YTD 15 YTD Source: Standard & Poor s Leveraged Commentary & Data, J.P. Morgan Securities LLC; data as of September 3, 215. *Lower-rated activity is credit rated Split B or below. J.P. MORGAN ASSET MANAGEMENT 3

4 THE CASE FOR HIGH YIELD: VALUATIONS Excess spread The spread over Treasuries in the high yield market primarily serves to compensate investors for loss due to default. Excess spread is the spread above Treasuries after accounting for expected defaults. The greater the excess spread, the better. Excess spread can also be considered a cushion for investors for unexpected loss due to higher defaults or perhaps lower recovery rates. Excess spread should not be zero. As with all risk assets, excess spread should exist for unexpected volatility events that generally impact risk assets to a greater degree than risk-free assets. Various studies have shown that average excess spread for the high yield market over the last 25 years has been in the range of 25bps 3bps. Based on recent trading levels, we calculate the excess spread at 524bps, roughly twice the 25-year average (projecting the current default rate and assuming 4% recovery). In other words, spreads have considerable cushion to absorb a much higher rate of default (EXHIBIT 3). Indiscriminate performance pressure Sectors mainly exposed to developed markets growth have been indiscriminately pressured along with those sectors (energy, basic materials) more directly impacted by the slowdown in demand from China and other emerging markets. Consider: At the end of January, only two of 18 mid-level sectors posted negative year-to-date returns energy and basic materials. At the end of September, seven of the mid-level sectors reported negative returns year-to-date: energy, %; basic materials, -7.42%; telecom -4.32%; media, -2.24%; financials, -.85%; utilities -.6%; and automotive, -.21%. (In October, as flows increased and sentiment healed, those sectors retraced to higher levels.) The energy and basic materials sectors are more directly impacted by the slowdown in China s demand. However, the vast majority of the remaining sectors are much more exposed to developed markets growth. Charter Communications 2 is an example of a high yield issuer with no emerging markets exposure. A publicly traded, leading U.S. Internet broadband company, Charter recently acquired Time Warner Cable. Charter has 4.5 turns of debt leverage and substantial free cash flow; its bonds are rated B1/BB-. Charter bondholders have considerable protection, with over $2 billion of equity market value beneath them in the capital structure. All of Charter s revenues 1% are generated in the U.S. Yet as of September 3, Charter 5¾ 24 traded at $95.75, yielding 6.42%, or 55bps over Treasuries, down from $12.5 in August. Don t fear the Fed tightening cycle It is well understood that the Fed begins a rate hiking cycle when current and forecasted economic conditions are robust and threatening to become too robust. It follows that credit conditions at the beginning of a tightening cycle are also 2 We are not recommending Charter Communications but solely using it as an example. Spreads have considerable cushion to absorb a much higher rate of default EXHIBIT 3: JPMORGAN DOMESTIC HIGH YIELD INDEX AND TRAILING 12-MONTH DOMESTIC DEFAULT RATE Domestic HY default rate (%) Default rate low 1993 thru 1999 = 1.2% Average default rate = 2.5% Average spread = 423bps Default rate low 23 thru 27 =.3% Average default rate = 2.1% Average spread = 448bps 2, 1,8 1,6 1,4 1,2 1, Jan-87 Jan-88 Jan-89 Jan-9 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Jan-1 Jan-11 Jan-12 Jan-13 Jan-14 Jan-15 Domestic HY default rate Domestic HY spread to worst HY spread to worst (bps) Source: J.P. Morgan Securities LLC. The above information is shown for illustrative purposes only. 4 THE RETURN OF YIELD TO THE HIGH YIELD MARKET

5 Spreads don t widen substantially until well after the end of the rate hike cycle EXHIBIT 4: HISTORICAL SPREAD LEVELS AND FED FUNDS RATE Fed funds rate Jan-87 Fed funds rate Jan-88 Jan-89 Jan-9 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan- Jan-1 Jan-2 Jan-3 Jan-4 Jan-5 Jan-6 Jan-7 Jan-8 Jan-9 Domestic HY spread to worst Jan-1 Jan-11 Jan-12 Domestic HY stw 76bps Fed funds rate.25 Jan-13 Jan-14 Jan-15 2, 1,8 1,6 1,4 1,2 1, HY spread to worst (bps) Source: J.P. Morgan Asset Management. The above information is shown for illustrative purposes only. generally strong, capital markets receptive and risk assets well bid in short, it is a favorable environment for high yield. As EXHIBIT 4 illustrates, high yield spreads have remained relatively steady throughout previous rate hike cycles. Spreads don t widen substantially until well after the end of the rate hike cycle, when credit conditions are tighter, capital markets less receptive and investors less consistently willing to bid for risk assets. As tighter credit conditions work their way through the economy, more levered, poorly positioned credits eventually succumb, spreads widen and a new default cycle begins. When rates rise because of Fed tightening, high yield spreads should provide a cushion to partially absorb the impact of the rate move. This spread makes high yield somewhat insulated to rate hikes when compared with other fixed income asset classes. The cushion partly explains why high yield has a lower correlation to Treasuries relative to most other fixed income asset classes. Today high yield spreads are wider than they were at the start of the four previous tightening cycles, which means they already have a considerable cushion. Continued on next page J.P. MORGAN ASSET MANAGEMENT 5

6 CONCLUSION: FUNDAMENTALS FIRST AND FOREMOST In any market environment, high yield has an important role to play in a disciplined, well-diversified asset allocation. In the current environment, as we consider opportunities in the high yield market we must acknowledge the wide range of exogenous events that can impact investor risk appetite. Emerging markets growth, U.S. politics, tensions in the Middle East and a wide range of geopolitical forces have an uncertain impact on global growth prospects. Certainly, they pose increased risk to all risk assets. Looking specifically at the impact of the China slowdown and commodity weakness on global growth, we see increased risks to the high yield market. Nonetheless, we expect the majority of high yield issuers to maintain solid fundamentals with reasonable growth in revenues and cash flows (ex-energy and commodity-related sectors) as shown in EXHIBIT 5. The vast majority of high yield issuers should benefit from the decline in commodity prices, either through higher demand from their customers or lower cost inputs. We observe, too, that recent global economic uncertainty and resulting volatility have dramatically increased dispersion by ratings bucket, sector and issuer. This presents a significant opportunity for active management. As we have noted, current spreads are now above their longterm averages while defaults are well below their long-term averages. Moreover, current spreads are significantly wider than they were during previous periods of similar default rates. These spreads assume a higher risk of recession in developed markets than we think is reasonable, and they imply much higher and broader default experience than we would anticipate. Yield and opportunity have returned to the high yield market. High yield fundamentals are supportive EXHIBIT 5A: REVENUES AND EBITDA HAVE FALLEN IN Revenues y/y Ebitda y/y Q9 2Q9 3Q9 4Q9 1Q1 2Q1 3Q1 4Q1 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 EXHIBIT 5B: LEVERAGE LEVELS REMAIN REASONABLE 5.3x x x x 4.5x x x x x 3.5x Multiple 1Q8 2Q8 3Q8 4Q8 1Q9 2Q9 3Q9 4Q9 1Q1 2Q1 3Q1 4Q1 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 EXHIBIT 5C: COVERAGE RATIOS REMAIN HEALTHY 6.x Ebitda-CAPEX/interest expense Ebitda/interest expense Multiple 5.x 4.x 3.x 2.x 1.x.x 1Q8 2Q8 3Q8 4Q8 1Q9 2Q9 3Q9 4Q9 1Q1 2Q1 3Q1 4Q1 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 EXHIBIT 5D: COMPANIES HAVE REDUCED CAPEX SPENDING Q9 2Q9 3Q9 4Q9 1Q1 2Q1 3Q1 4Q1 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14 1Q15 2Q15 Source: Standard & Poor s Leveraged Commentary & Data, J.P. Morgan Securities LLC; data as of June 3, THE RETURN OF YIELD TO THE HIGH YIELD MARKET

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