In the short time since high yield bonds have been recognised as a mainstream asset class, they have undergone several cycles of popularity from loved to loathed and back. High yield bonds can therefore be likened to a badly-behaved celebrity. Initially loved and then pilloried for some moral failure, they tend to spend a period in the wilderness before eventually undergoing redemption and lionisation in advance the next fall.
High yield borrows tend to be dependent upon favourable financial conditions
Yet through these cycles, high yield bonds, like the badly behaved celeb, become increasingly familiar and accepted as part of the fabric of investment life. The source of this continual gyration stems from the nature of the underlying activity that lies behind these assets, i.e. lending money to companies which have a significant possibility of defaulting.
What Causes Volatility in the High Yield Bond Market?
The ability of these borrowers to repay their lenders typically relies on a positive tailwind from economic or business conditions. In addition, high yield borrows tend to be dependent upon favourable financial conditions as many high yield bonds are re-financed rather than repaid. This requirement for a positive tailwind to deliver the return of the capital invested, let alone an attractive rate of return on the capital, would appear to fix these assets as a natural home for the capital of optimists rather than pessimists.
However, some of the most successful high yield investors are also among the most pessimistic. These pessimists tend to be the type of investors that put long term capital to work when short-term, momentum-driven investors are abandoning such assets.
At the far end of the spectrum are distressed debt investors who typically buy bonds issued by companies already in default and seek to extract as much value as possible through restructuring. While distressed debt strategies are not normally suitable or available for retail investors, distressed-debt investors are simply an extreme example of valuation-driven investors who are prepared to adopt an independently-minded approach. These investors are becoming increasingly interested in high yield bonds as prices fall, credit spreads, the additional interest received over that paid to holders of government debt of a similar maturity, widen and fears of default increase.
How Energy Price Falls are Impacting High Yield Bonds
The current conniptions affecting the high yield market are being driven primarily by the exposure of the asset class to US energy companies and, in particular, those involved in the production of shale products. The dramatic fall in energy prices over the last year has significantly reduced the revenue of these businesses, leading to a 35% year on year fall in revenue for Q4 2015 for energy companies in the S&P 500. This has resulted in a corresponding decrease in the ability of high yield shale companies to pay their debts.
While the price falls affecting the energy company bonds may be fully justified, given the dramatic change in market conditions, the negative sentiment created by these price falls has swiftly extended to other parts of the market with the result that even companies which benefit from the decline in energy prices, via input costs or increased consumer disposable income, have also suffered.
Evidence for this is provided by the average credit spread for US auto manufacturers, which has risen more than 300 basis points since the beginning of 2015 and currently stands at 738 bps. The transmission mechanism that has led to these broader prices falls can be traced to several factors.
What Else is Causing Price Falls?
The first of these is a structural change in the liquidity provision of investment banks. As capital rules have tightened, investment banks hold less inventory and therefore are unable to buy and hold bonds when prices are attractive. The second is forced selling by fund managers as capital has left the sector. Over the last six months the Morningstar High Yield Bond category has witnessed outflows of nearly $24 billion.
This outflow exacerbates the liquidity problem caused by the lack of inventory carried by investment banks. The third factor is concern about the health of the global economy given the slowdown in China and fear that falling demand for oil has contributed to the decline in energy prices.
While it is inherently difficult to predict the outcome for bonds issued by energy companies, given the impact of unpredictable energy prices to the financial security of these companies, situations involving ‘collateral damage’ are always interesting for fundamental investors who are prepared to dig a little deeper to find genuine value.
As we have studied this asset class over the last few months, it appears to us that high yield bonds currently offer good value, especially compared to government bonds, in most economic scenarios. This may be simply demonstrated by examining the current spread offered by these bonds in various default scenarios.
Previous global crises have led to annual default rates of around 10%. The US high yield market currently offers an 8% credit risk premium and provides a good income cushion in case the worst case scenario materialises. On the other hand, if next year default rates converge with consensus expectations, then investors should achieve a comfortable mid-single digit return.
It is for this reason that we have recently been adding high yield debt exposure to our portfolios, having previously avoided this asset class due to concerns that long term investors were not being appropriately rewarded for the additional risk of holding these bonds.
Before You Invest in High Yield Bonds…
However, the decision to invest in high yield bonds should not be taken lightly and we would recommend adhering to three key principles when putting capital to work in this area. Firstly, remember that defaults are the main enemy of bond investors as they typically entail a permanent loss of capital. However, defaults are specific events that affect a single issuer or bond. Consequently, their impact can be lessened by owning a broadly diversified portfolio.
Second, high yield credit instruments are typically far more complicated than equity securities, conveying varied levels of security. A high quality active fund manager can therefore significantly add value in this market, especially during periods of stress.
Finally, it is essential to have a realistic appraisal of the maximum price decline that may occur over the cycle. Many otherwise excellent investors fared badly in 2007-2008 by putting too much capital to work in high yield debt too early. When addressing these valuation-driven opportunities, we tend to espouse a gradual approach, with the size of investment increasing as prices move further from fair-value. While this approach can result in opportunities not being fully exploited as prices start to recover before the investor has put all their capital to work, it nevertheless helps reduce the possibility of the investor being forced to exit a position where they have lost too much money.
While Kayne’s often-cited quotation about the perils of leveraged investing, that “the market can remain irrational longer than you can remain solvent”, may not be directly relevant, an amended version – the market can remain irrational longer than you can remain employed – may be worth adopting when engaging with the high yield market.
This article was originally published in International Investment magazine
