High Yield Bonds have outperformed again in October adding to impressive year-to-date gains, as measured by the Barclays High Yield Bond Index. The strength in the market has led to record performance and eye popping total returns are causing investors to logically question, “is it over?” We do not believe it is over as valuations still look attractive and fundamental data continues to improve. Data on arguably the most important factor, defaults, suggests the favorable backdrop will persist for the high yield market.
When assessing the high yield bond market, default data is the most important fundamental driver. Both major ratings agencies, Moody’s and S&P, track defaults among companies rated below investment grade and publish their fi ndings monthly. Not only do they track current and past defaults but each firm reports their expectations for future defaults. While the level of defaults is high now, 12% according to Moody’s, it is a running total of the past 12-months and therefore a backward looking measure. Even within this backward looking measure there is cause for optimism as the number of
companies defaulting declined to 50 during the third quarter down from 83 during the second quarter and 89 during the first quarter.
However, the ratings agencies publish default forecasts and these are of more importance to forward looking markets. Last week S&P forecast the default rate would fall to 6.9% by September 2010, a sharp reduction versus their prior expectation of 13.9%. The news gave the high yield market a lift. S&P’s forecast is now more inline with that of Moody’s who had already forecast a drop in the default rate to 4.5% by September 2010. The S&P forecast is inline with that of other Wall Street analysts calling for a decline in defaults to 4.5% to 5.5% over the coming 9 to 12-months.
The default rate is perhaps the key driver of high yield bond valuations hence its importance. Higher defaults will cause investors to demand a lower price/ higher yield to compensate for default losses. The higher the expectation for defaults, the cheaper (or lower) high yield bonds are priced and vice versa. Historically the average high yield bond yield advantage over Treasuries, or spread, is highly correlated with the default rate.
Given the tight relationship, a continued decline in the default rate bodes well for the high yield market and suggests that there is still room for additional yield spread contraction. For example, if defaults do decline to 4.5% to 6.0% then yield spreads could contract to 6.0% to 6.5%, based upon the historical relationship between defaults and yield spreads, down from a current level of 7.7%. The prospect of additional yield spread contraction is particularly important given the improvement that has already occurred in other segments of the bond market. In other words, further declines in the default rate provide a tailwind for high yield bonds and help generate additional return.
The high yield market also offers higher yields, something that is becoming increasingly important. Yields on Treasuries and Mortgage-Backed Securities (MBS) are at or near historic lows. Investment grade corporate bond yields are at their lowest levels of the past four years. As the pace of improvement for many fixed income sectors slows, interest income will play a much greater role in driving performance going forward. The average yield of high yield bonds is 10.0%, slightly below its long-term average of 11% but well above the 2004 low of 6.7%.
Yields Are Attractive
The attractive yield should continue to attract demand from investors. The average high yield bond still possesses a large yield advantage to money market investments. The current yield advantage is down but above the 2002 peak, which was another opportune time to buy high yield. The sector has benefited from investors switching out of cash and with over $3 trillion still sitting in money market instruments, will likely continue to do so. While we remain favorable on the high yield market there are still risks to consider. Year to date new issuance has totaled $133 billion, more than twice the 2008 total of $53 billion according to Bloomberg. A smoothly functioning new issue market has been a key factor in driving the default rate lower. Many companies have been able to refinance debt obligations and lower interest expense or restructure near-term maturities. Should the new issue market falter and companies not be able to issue new debt or refinance existing debt, default risk would increase. A “double dip” recession would also be a risk but we expect the economy to continue to expand at a modest pace. Economic growth, even at a modest pace, should provide a favorable
backdrop for high yield issuers.
Absent a sharp decline in economic activity (which we do not expect) or a quick reversal in default expectations we expect to continue to hold high yield bonds well into 2010. Should yield spreads contract to a level that fully reflected the decline in defaults we would consider exiting the high yield bond market. Alternatively if high quality bond yields rose substantially to provide attractive return opportunities we might also consider switching out of high yield bonds. We do not expect either condition but these are the signposts we are watching.
So while the high yield bond market has had an impressive run in 2009, we believe fundamentals outweigh risks and bode well for additional positive return. To be sure, 2009 total return should be viewed in the context of an extremely depressed 2008. We believe the bulk of the gains are behind us and the now higher valuations suggest the pace of performance will slow.
We still view the sector as the most attractive in fixed income. In a world of lower yields and higher valuations, high yield bonds still offer both attractive valuations and yields. The run is not over for high yield bonds.
- This report was prepared by LPL Financial. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- Government bonds and Treasury Bills are guaranteed by the US government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fi xed principal value. However, the value of funds shares is not guaranteed and will fluctuate.
- The market value of corporate bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and are subject to availability and change in price.
- High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.