Morningstar's "Perspectives" series features investment insights from third-party contributors. Here, Bill Eigen, manager of the JPMorgan Income Opportunity Fund explains how the bruised US high yield credit market is compensating investors incredibly well.
Investor risk sentiment has taken a battering and the US high yield market has the bruises to prove it, but the sector also offers tremendous value – in fact the sector is one of my highest conviction investment ideas.
The case for US high yield based on three considerations:
Valuations
US High Yield prices are very depressed, currently nearing where they bottomed out during the tech bust, creating an attractive entry point
Fundamentals
The underlying fundamentals for US high yield look very reasonable. Certainly it is true that leverage is higher than it was a few years ago, but this is only marginally the case. Interest coverage ratios are at record high levels, so companies have the ability to service their debt very comfortably.
Technicals
Technical factors have really been the drivers of high yield price weakness in recent years. If we look at the patter of flows in and out of the sector, between 2010 and the midpoint of 2014, US high yield received tremendous inflows. But from that point to the middle of February of this year, nearly all of those flows had left. It begs the question of who is left to sell at this point? Much of the so-called high yield ‘tourist’ money seeking to pick up yield has now left the sector and been flushed out. As a result, we may see a number of crossover buyers from equities starting to come into the market.
Investors are Overestimating the Impact of Energy
Exposure to the struggling energy sector has unquestionably been an albatross for US high yield, but investors may be overestimating the impact of energy weakness on the broader high yield market. Today the energy and commodities complex makes up about 12% of the US High Yield market index. If we looked at this a year ago, it would have been closer to 17%.
Even if we were to hypothetically presume that 50% of energy companies exit the index by default, and that they exit at a statistically lower than average recovery rate of 20 cents on the dollar, that would translate to a loss of 5%-6%. Considering investors are earning close to 10% yield overall, we’re still looking at 4%-5% total returns even in that dire scenario. Put another way, simple arithmetic shows the massive yield advantage currently on offer.
Liquidity is another consideration driving prices lower in high yield. Because liquidity is constrained in an outflow scenario, the sector has seen significant price depreciation, another factor making valuations attractive.
We don’t advocate an index tracking approach to US high yield, citing the need for flexibility to de-emphasise challenged areas and focus instead on companies and sectors consistent with the powerful theme of the world entering a ‘services super cycle,’ including areas like healthcare, pharmaceuticals and telecoms – things that have little to do with where the price of oil is trading. Unconstrained active managers who are not tied to benchmarks that reflect weightings to energy and commodities have an advantage, in that they have the ability to pick up names at significant value driven by fundamental research.
For those able to take a selective investment approach, US high yield is a major opportunity. The last few years of high yield underperformance has been driven by significant outflows from the macro level, but nothing major has changed with companies in the space, ex-energy sector, apart from the flows pattern.
While it might be a bumpy trajectory on the way up, in an income starved world, where else investors going to find assets backed by decent fundamentals providing 10% yield? In a world where nearly every central bank has likely deployed most of its monetary policy tools and traditional fixed income is barely eking out positive returns, high yield looks attractive and is currently compensating investors far more than their fundamentals would seem to merit.
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