Market Memo: High-yield fundamentals remain favorable
As noted earlier this year, the high-yield market isn’t likely to perform in 2013 as well as it has over the past four years. But the data two months into this year suggest 2013 is shaping up as another good one for high yield, particularly relative to most other fixed-income sectors.
Despite Washington’s best efforts to mess it up, the economy appears OK. Housing and auto sales are picking up, manufacturing activity appears to be accelerating, the labor market is slowly improving and consumers are hanging in despite higher payroll tax and higher gasoline prices. On the corporate side, balance sheets and cash flow are solid, and the earnings season was decent even though headline revenue growth was subdued if not disappointing.
All of this makes for a good backdrop for high yield, which is why we recently nudged up our overweight position in the sector in our overall bond portfolio models. While high-yield spreads—yields relative to comparable maturity U.S. Treasuries—have fallen to within their historical median, it’s worth reiterating that in times of economic growth such as we are experiencing now, spreads generally spend a considerable time below the median and typically bottom out in the mid-to-low 300s. This suggests there’s still some upside on the valuation front. At the same time, the average yield of around 6% is relatively attractive in a fixed-income world where yields of even 5% are hard to find.
Defaults historically low
Moreover, defaults remain historically low, with 2012’s default rate below 2% for a third straight year, according to New York University’s Edward Altman, well below their long-term average of 3.5% to 4% (see table below). While Altman is projecting defaults to rise to just above 3% this year, our team at Federated believes we may see another 2% or below number based on the economic factors cited above and on our corporate research.
Annual default rate
|Year||Altman default %||Federated default %|
For what it’s worth, our analysis is bottom-up driven, while Altman’s is based on a more technical top-down/statistical analysis, and most Wall Street strategists are in line with our number (Altman overestimated defaults the past three years, projecting rates of 5.06%, 3.90% and 4.10%, respectively, for 2010, 2011 and 2012). Also, the early-to-mid 1980s saw six out of seven consecutive years of sub-2% default rates, the mid-’90s saw six consecutive years below 2% and the 2000s’ somewhat truncated cycles saw three out of four years with sub-2% default rates, so three years running below 2% is not all that unusual nor would additional years of sub-2% default rates be unusual.
One caveat to our 2013 default-rate expectations are a couple big leveraged buyouts from the 2007 period, most notably Caesars and Texas Utilities, that at some point will likely need to restructure their debt. These represent pretty significant par value and will cause a modest impact to the default rate. The important point is that the bond prices currently reflect the likely defaults, so it may cause the rate to spike a bit but will have minimal market performance impact.
In sum, we expect the good start to the year for high yield to continue.