The case for high yield Jennifer Ponce de Leon, Vice President, Senior Sector Leader Wendy Price, Director, Institutional Product Management We believe high yield is a compelling relative investment opportunity given the fundamental repair that has taken place for a large part of the high yield corporate universe, the low expected default rates over the next several years and valuations that are attractive compared with historic averages and reflect greater-than-expected defaults. Any improvement in sentiment could lead to improvement in valuations. Given the murky outlook to the economic backdrop, we believe high yield offers a strong investment opportunity, especially relative to other risk asset classes. In the following article, we explore several factors that contribute to a compelling case for high yield, including: > > Fundamentals. Leveraged issuers have increased cash levels, deleveraged their balance sheets and refinanced looming maturities. Amortization requirements over the next two years are quite manageable and will likely help keep default rates below historical averages. > > Valuations. Yield premiums for lending to leveraged issuers are wider than year-end 21 and should help cushion any potential volatility. > > Attractive risk/return profile relative to equities. Over the last 25 years, high yield bonds have achieved similar average annual returns with half of the volatility when compared to equities (as measured by the S&P 5 Index), owing to the high coupon component of high yield bonds. > > Uncertain economic growth environment. History shows that performance in high yield is not contingent on strong economic growth and that, in low growth environments, high yield bonds tend to perform reasonably well. > > Reduced interest rate sensitivity. High yield is an asset class that tends to be less interest rate sensitive relative to other fixed income alternatives, and the key drivers to performance are credit fundamentals. Fundamentals Corporations are well-positioned to manage through a period of slow growth, which supports our constructive outlook for the high yield asset class. The fundamental improvements companies have made in terms of balance sheet liquidity, overall leverage, interest burden and amortization requirements over the next several years will likely keep default rates below historical averages for the next two years. Meaningful refinancing activity beginning in 29 has reduced the maturity schedule through 214 by $56 billion. Maturities in 214 are the next hurdle, particularly in leveraged loans. The maturity schedule is much less ominous today than it was in 28, as maturities are more laddered out (see Exhibits 1 and 2). This is a key to keeping default levels low over the next several years, which is supportive of the high yield asset class. Over the 72
next two years, we expect default rates to remain well below their long-term average of 4.2%. Our own internal default expectations based on fundamentals suggest an issuer weighted default probability of less than 2%. Moody s and J.P. Morgan s default expectations for 212 are 2.2% and 1.5%, respectively (see Exhibit 3). Exhibit 1: Bond and loan maturities (Then and now 28) $ billions 35 3 25 2 223 316 15 125 126 114 15 1 92 76 73 76 61 64 67 5 24 25 1 1 8 211 212 213 214 215 216 217 218 219 22 or later High-yield bonds Institutional leveraged loans Exhibit 2: Bond and loan maturities (Then and now 211) $ billions 3 25 2 162 162 154 15 143 143 136 125 13 1 84 85 65 5 54 5 39 15 16 1 2 211 212 213 214 215 216 217 218 219 22 or later High-yield bonds Institutional leveraged loans 287 Exhibit 3: Moody s global default rate percent of issuers Global Default Rate % 16 14 12 1 8 6 4 2 1985 2-yr average rate = 4.46 1987 1989 1991 12.79 1993 1995 1997 Source: Moody s, October 211 1999 21 1.89 23 25 27 29 13.4 High yield issuer fundamentals remained stable in the second quarter of 211. According to the Bank of America sample set of approximately 5 high yield issuers, of which 475 have reported, year-over-year revenue growth was 12% for the second quarter, up from the first quarter rate of 7.4%. Earnings before interest, taxes, depreciation and amortization (EBITDA) also continued to grow year-overyear at an average rate of 18%, up from 6.4% in the first quarter. However, with greater economic uncertainty, earnings growth is unlikely to keep pace with that seen in the first half of 211. Exhibit 4: Net leverage decreased to 3.3x from 3.5x in Q1 Net Leverage (Net Debt/LTM EBITDA, x) 4.5 4.3 4.1 3.9 3.7 3.5 3.3 3.1 2.9 2.7 2.5 1996 1998 2 22 24 26 28 21 Leverage ratio Average leverage (3.6x) Source: BofA Merrill Lynch Global Research, Second quarter 211 211 1.9 73
Exhibit 5: Similarly, interest coverage increased to 4.x from 3.5x in Q1 Coverage (LTM EBITDA/Net LTM Interest Expense), x 4. 3.5 3. 2.5 2. 1996 1998 2 22 24 26 28 21 Coverage ratio Average coverage (3.2x) Source: BofA Merrill Lynch Global Research, First quarter 211. Valuations Although there are risks to the downside, we believe valuations in the asset class have priced in many of these risks and remain attractive relative to historical averages. Valuations have sold off and spreads are wider now than they were at the start of 211. Valuations today are pricing in greater-than-expected defaults, even when considering the most stressed default scenarios. The additional risk premium helps to cushion against volatility in the marketplace. Spreads at current levels of 719 basis points (bps) (as of October 31, 211) are wide compared to the 2-year average of 579 bps, while yields of 8.22% are inside the 2-year average of 1.33%. Exhibit 6: High yield market valuation (Yield to worst) Yield to worst (%) 19 17 15 13 11 9 7 5 Oct 9 19.12% 2-year average = 1.33% Nov 8 2.15% Dec 4 6.97% Oct 11 8.22% Jan 87 Jan 88 Jan 89 Jan 9 Jan 91 Jan 92 Jan 93 Jan 94 Jan 95 Jan 1 Jan 5 Jan 6 Jan 7 Jan 8 Jan 9 Jan 1. Exhibit 7: High yield market valuation (Spread to worst) Spread to worst 2,bp 1,8bp 1,6bp 1,4bp 1,2bp 1,bp 8bp 6bp 4bp 2bp 2 Yr. Avg. = 579 bp Oct 9 1,96 bp Nov 8 1,789 bp May 7 269 bp Jan 87 Jan 88 Jan 89 Jan 9 Jan 91 Jan 92 Jan 93 Jan 94 Jan 95 Jan 1 Jan 5 Jan 6 Jan 7 Jan 8 Jan 9 Jan 1. Past performance does not guarantee future results. Technicals Strong corporate fundamentals and attractive valuations are further supported by a positive technical backdrop for the asset class. The marketplace and dealers are set up very differently than they were in 28. Inventory levels have decreased meaningfully from mid-28 levels before 74
the financial crisis peaked. There is also significantly less leverage in the system. Other technical factors, such as bridge risk, collateralized loan obligation warehouse levels and total return swap lines, have also come down significantly since 28. Liquidity is still challenged given volatility in the market. However, the high yield asset class is typically considered less liquid relative to other fixedincome sectors. Attractive risk/return relationship In the wake of recent market volatility, there is a strong case for high yield, particularly relative to equities. According to JPMorgan and S&P data, high yield bonds have achieved similar average annual returns with half of the volatility over the last 25 years (see Exhibit 8). The high coupon component of high yield bond performance leads to less return volatility relative to equities, resulting in a more attractive risk-adjusted return opportunity. This is especially relevant now given the uncertainty in the macroeconomic backdrop. Investments in high yield bonds still allow for participation in the upside as the economy begins to recover, but with less exposure to downside volatility relative to the equity market, where performance is fueled by sustained economic and earnings growth. Exhibit 8: 1-year rolling return per unit of risk 1-year risk/return 2. 1.5 1..5. -.5 Jan 1 Jan 5 Jan 6 Jan 7 Jan 8 Jan 9 Jan 1 JPM Global HY Index S&P 5 Uncertain economic growth environment History shows that performance in high yield is not contingent on strong economic growth and that in lowgrowth environments, high yield bonds tend to perform reasonably well. In previous periods when the growth rate was between % and 2%, high yield bonds returned 3.86% on average, with a standard deviation of 8.52%. This compares with an average return from equities of 4.11% and a standard deviation of 15.7%. Although equities experienced slightly higher average returns, high yield bonds were able to achieve a similar return profile with half the volatility. In addition, the lower growth is likely to keep the Federal Reserve on the sidelines. Exhibit 9: High yield and equity returns during periods of low GDP Growth (>%, <2%) between 1986 and 211 2.% 15.% 1.% -5.% Average Quarterly HY Return = 3.86% Average Quarterly S&P Return = 4.11% -2.7 8.4 9.7 9.5 6.3 6.5 5.7 6. 6.1 6.5 6. 5.6 4.9 5.3 5.% 4.4 3.1 2.1 2.3.6.% -1.6 8.4 6.9 7.1 2.6 1.4.2 Dec 86 Dec 89 Jun 9 Sep 91 Dec 91 Mar 93 Mar 95 Jun 95 Mar Sep Dec 1 Dec 2 Mar 3 Jun 5 Jun 6 Sep 6 Mar 7 Dec 7 Jun 8 Sep 9 Mar 11 Jun 11 GDP Growth BofA Merrill Lynch High Yield Master S&P 5 Source: JP Morgan, June 211 Past performance does not guarantee future results. -1. 1.7-3.1-1.4 4.1 5.7 2.7.6-1.2 1.8-3.3-2.7 15.6 14.8 3.9 5.9 1..1 75
Reduced interest rate sensitivity Historically, high yield bonds have generally outperformed other fixed income alternatives in rising rate environments. The excess spread and moderate duration of high yield bonds make them less sensitive to interest rate fluctuations. High yield bonds are more correlated with economic growth than interest rates. In a typical economic recovery, credit spreads are expected to narrow with the improvement in business conditions. This provides a cushion and potential offset to the price deterioration that occurs when Treasury rates eventually rise. In addition, the substantial income pick-up from high yield bonds looks attractive relative to other sectors of the fixed-income market in an environment characterized by low yields and low growth. High yield bonds also benefit from less price sensitivity to interest rate movements given their moderate duration, offering better protection from interest rate risk in the event the economy begins to grow faster. Another important factor supporting high yield performance in rising rate environments is that historical correlation between high yield bonds and 1-year Treasuries is relatively low. Over the past decade, the correlation between the two markets has been negative at -.17%. However, this relationship has been characterized by periods of strong association between the two markets (as high as +6% correlation (JPMorgan)), followed by periods of negative correlation. The level of high yield spreads affects the relationship between the two markets, with tight spreads normally associated with strong positive correlation and wide spreads associated with periods of strong negative correlations. Conclusion Given the considerable challenges in today s market environment, we expect continued volatility in the high yield sector. However, we believe investors who have a long-term investment horizon are offered ample compensation for the risks in the market and are likely to enjoy strong riskadjusted returns relative to other risk asset classes. We continue to believe bottom-up credit selection will be a key driver of relative performance for the remainder of the year, as it will be important to determine which issuers and industries will be less impacted by macro headwinds. In our view, there are very good risk-adjusted values in the marketplace and we will look to invest incremental dollars in the mid to higher quality portion of the market. We are very selective in adding risk and may look to reduce risk on the margin if valuations improve given the increased risks to the economic backdrop. We will continue to maintain our disciplined credit selection based on strong fundamental analysis and rigorous risk management in order to take advantage of opportunities in the marketplace. There are risks associated with fixed income investments, including credit risk, interest rate risk, and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is more pronounced for longer-term securities. Non-investment grade securities, commonly called high-yield or junk bonds, have more volatile prices and carry more risk to principal and income than investment grade securities. The Bank of America Merrill Lynch High Yield Master Index tracks fixed-rate, coupon-bearing bonds with an outstanding par that is greater or equal to $5 million, a maturity range greater than one year, and a rating less than BBB/Baa3 rated, but not in default. The Standard & Poor s (S&P) 5 Index tracks the performance of 5 widely held, large-capitalization U.S. stocks. 76