Market Bulletin. November 7, U.S. High Yield: A bubble set to burst?

Transcription

1 November 7, 2014 U.S. High Yield: A bubble set to burst? Grace Tam, CFA Vide President Global Market Strategist J.P. Morgan Funds Katy Fang Research Analyst J.P. Morgan Funds Tai Hui Managing Director Chief Market Strategist Asia J.P. Morgan Funds The sell-off in U.S. high yield corporate bonds in recent months has raised fears over whether a bubble is set to burst in the high yield space given the robust inflows into the asset class in search for income in the aftermath of the global financial crisis. Valuations in late June had left little cushion for rate or credit volatility. We would expect continued episodes of market volatility around global growth concerns and evolving global central bank policies. Nevertheless, the positive U.S. economic outlook as well as the solid credit fundamentals for U.S. high yield issuers in general remain supportive to the asset class in With sentiment towards the high yield universe much less complacent now, the recent correction provides good value opportunities for investors. Interest rate hike cycles are not necessarily harmful Concern over the timing of the Fed s first interest rate hike was one of the key reasons for the summer sell-off. History never repeats itself, but looking into how U.S. high yield markets performed in previous Fed rate hike cycles may give us a reference point. On examining U.S. high yield bond spreads for the previous four Fed rate hike cycles (1987, , and ), Chart 1 shows that on two occasions spreads were up quite significantly (1987 and ). The widening was mainly concentrated on the latter part of the rate hike cycles when interest rates were already at high levels. Spreads were either range bound or had narrowed in the early cycle stages and throughout the rate hike cycles in 1994 and CHART 1: SPREADS OF BOFA MERRILL LYNCH U.S. HIGH YIELD MASTER II INDEX OVER PAST RATE HIKE CYCLES Option-adjusted spread, bps 2400 Rate Hike Cycles '85 '87 '89 '91 '93 '95 '97 '99 '01 '03 '05 '07 '09 '11 '13 Source: The Federal Reserve, BofA Merrill Lynch, FactSet, J.P. Morgan Asset Management, October 2014.

2 U.S. high yield bonds in general are less sensitive to interest rate hikes compared with their investment-grade peers and U.S. Treasuries given their relatively shorter duration. Combined with their higher coupon rates, which can offset some of the price declines due to rising interest rates, investors total returns tend to remain attractive compared with other asset classes within the fixed income world, as demonstrated in Chart 2. CHART 2: TOTAL RETURN IMPACT IN A RISING YIELD ENVIRONMENT Asset classes, rolling 3-month average total return (USD), YTD Convertible Bonds U.S. High Yield Asian Bonds (USD) EMD (USD) EMD (LLC) IG Corporate U.S. Aggregate -0.7% -0.7% 1.4% 1.3% % 4.2% Favorable U.S. economic outlook is the key The key risk that investors should always keep an eye on when investing in U.S. high yield bonds is the default risk. As indicated in Chart 3, there is a close negative correlation between U.S. GDP growth and U.S. high yield default rates over the past 28 years. As of September, default rates have dropped to 1.5%, with the trailing 12-month par-weighed default rate (ex-txu default) only 0.53%, versus a peak of 14% during the global financial crisis, and have remained below the long-term average of 4.8% since late We believe the recovery story for the U.S. remains intact in This could reasonably imply that default rates can remain at relatively low levels, providing high yield investors with favorable default-adjusted returns. Furthermore, so far in 2014 a recovery rate of 54% is higher than the 25-year annual average of 41%, which means that slightly more than half of a high yield bond s face value would be recovered should a default happen. U.S. 10-year Treasury -3.1% -5% -3% -1% 1% 3% 5% Source: Barclays, BofA Merrill Lynch, J.P. Morgan, FactSet, J.P. Morgan Asset Management, September Footnote: Periods of rising U.S. yields are defined as rolling 3-month periods when the U.S. 10-year Treasury yields increased by more than 25bps from January 1993 to September 2014, data permitting. Returns are total returns in U.S. dollar terms. Asset classes shown include Barclays U.S. Treasury (10-year) Bellwethers Index, Barclays U.S. Aggregate Index, Barclays U.S. Investment Grade Credit Index, J.P. Morgan GBI-EM Bond Composite Index, J.P. Morgan EMBI Global Index, J.P. Morgan Asia Credit Index (data since 1999), Barclays U.S. Corporate High Yield Index (data since 2002) and BofA Merrill Lynch U.S. Convertibles Index. CHART 3: U.S. DEFAULT RATES AND GDP GROWTH Quarter-over-quarter % change annualized 1 Default Rate (inverted scale) 5% 4% 8% -5% Recession GDP Growth Default Rate 12% -1 '86 '89 '92 '95 '98 '01 '04 '07 '10 '13 16% Source: BofA Merrill Lynch, U.S. Bureau of Economic Analysis, NBER, J.P. Morgan Asset Management, September

3 Robust corporate fundamentals Still strong corporate fundamentals add to the attractiveness of investing in high yield bonds. According to J.P. Morgan Global Credit Research s analysis, based on a sample of 491 U.S. high yield companies excluding the financial and utility sectors, the gross leverage ratio (debtto-ebitda) edged higher from a trough of 3.9x in to 4.2x in 2Q14, as companies took advantage of favorable funding conditions. This leaves the ratio far below the global financial crisis peak of 5.2x, as shown in Chart 4. CHART 4: GROSS LEVERAGE IS MUCH LOWER THAN CRISIS PEAK Last twelve months debt/ebitda 5.3x x 4.7x 4.4x 4.1x 3.8x 3.5x 1Q08 1Q09 1Q10 1Q11 1Q12 1Q13 1Q14 Source: Capital IQ, J.P. Morgan Securities, J.P. Morgan Asset Management, June Chart 5 shows that high yield companies revenue growth hit a 3-year high of 9.3% YoY in 2Q14, while EBITDA growth remains solid at 6.2%. Also, interest coverage (EBITDA-tointerest expense) has been stable in recent years at around x. All credit metrics are thus showing a healthy picture for U.S. corporate fundamentals, which suggests benign default risks for next year CHART 5: REVENUE AND EBITDA GROWTH REMAIN SOLID Year-over-year % change 45% 3 15% -15% Revenue EBITDA -3 1Q09 1Q10 1Q11 1Q12 1Q13 1Q14 Source: Capital IQ, J.P. Morgan Securities, J.P. Morgan Asset Management, June Furthermore, the maturity profile for U.S. high yield bonds looks favorable with no heavy maturity schedule over the next couple of years, as shown in Chart 6. This reinforces our message that default rates for U.S. high yield bonds are likely to stay at below average levels over the next couple of years. CHART 6: MATURITY PROFILE OF U.S. HIGH YIELD BONDS USD billions or later Source: J.P. Morgan Securities, J.P. Morgan Asset Management, September % 3

4 Is the quality of new issues deteriorating? Some investors worry about whether the quality of new high yield issues has been weakening. But Chart 7 shows that the new high yield issues rated single B or above account for more than 8 of total supply YTD, versus 7 before the financial crisis. In terms of the use of proceeds, refinancing still contributes the largest part (55%) of total supply so far this year, compared to only 4 before the financial turmoil, as demonstrated in Chart 8. However, investors should monitor the trend of the average rating as well as the use of proceeds for new issues closely, as a significant decline in quality could signal a frothy market that leads up to the next default cycle. CHART 7: NEW HIGH YIELD ISSUES BY RATING % of total face value More reasonable valuations after the recent correction The recent correction provides investors with opportunities to enter the market at better valuations. Before the correction, the spread to worst of the J.P. Morgan Domestic High Yield Index broke below the 400bps level to a 7-year low, with yield to worst dropping to 5%. The sell-offs in September and early October brought the spread and yield to worst back to 563bps and 6.8%, respectively. Market sentiment towards U.S. high yield bonds seems to have recovered slightly with spreads coming off their recent highs given strong inflows to the asset class over the past two weeks. From Chart 9, current spreads appear to be more in line with past average levels, offering more reasonable valuations than was the case earlier this year. CHART 9: SPREADS HAVE WIDENED DURING THE SUMMER SELL-OFFS Spread to worst, bps Y AVE: 577 '97 '99 '01 '03 '05 '07 '09 '11 '13 Source: BofA Merrill Lynch, FactSet, J.P. Morgan Asset Management, September CHART 8: REFINANCING REMAINS THE DOMINANT USE OF PROCEEDS % of total high yield issuance 10 BB B CCC 500 3Y AVE: Y AVE: '11 '12 '13 '14 Source: J.P. Morgan Securities, J.P. Morgan Asset Management, October YTD Refinancing Acquisition/LBO General corporate Source: J.P. Morgan Securities, J.P. Morgan Asset Management, September

5 Investment implications With the change of Fed policy taking place, investors should be prepared for more volatile high yield bond markets. Nevertheless, continued monetary easing measures by the European Central Bank and the Bank of Japan should partly offset the liquidity withdrawal from the Fed, and we believe global investors still view U.S. high yield bonds as one of the more attractive carry assets. Flight to quality due to global growth concerns, or a spike in government bond yields due to rising inflation pressure, are the key risks for U.S. high yield bonds. However, as long as the U.S. economy remains on its present recovery path and balance sheets of U.S. high yield issuers remain healthy, which is still our base case scenario, default rates should continue to remain at low levels in the next few years. While the Fed will likely start its rate hike cycle in 2015, history seems to suggest that from a total return perspective, U.S. high yield bonds can still provide a relatively attractive risk/reward profile for fixed income investors in a rising yield environment. 5

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