Market Memo: High yield keeps on humming
The high-yield market has been on a tear, prompting our investment team to question if our expectations for total market returns in the 6.5% to 9% range this year might be a little tepid. We’re already more than halfway to that goal just four months and change into 2013.
Of course, there always are going to be unforeseen bumps in the road and the market is due for a consolidation of recent gains. So we’ll hold off making any changes in our forecasts for now. That said, both market technicals and fundamentals appear to be very strong, driven by four key factors:
- An OK economy. It’s certainly not too hot but it’s not too cold, either—almost a perfect environment for high yield. This slow growth, and an all-in Fed, are mitigating increases in longer-term Treasury yields, causing spread tightening (the narrowing of the gap between high-yield and comparable maturity Treasury bonds, which have fallen from 500 to 444 basis points the past five weeks) to occur primarily on the price side of the equation. We had been expecting tightening to be a combination of both rising high-yield bond prices (which drive down yields) and rising Treasury yields, but because the latter really hasn’t happened yet, there’s a lot of ammo still in this gun, given that spreads tend to bottom out in the low- to mid-300 basis-points range.
- Credit quality is in great shape. The first-quarter’s annualized default rate was 1%, roughly a quarter of its long-term average of 3.5% to 4%. This is a story the financial press is largely missing by homing in on a relatively few high-profile problem children. New debt issues are being used primarily to refinance existing debt at lower rates and longer maturities—positives, not negatives, for corporate balance sheets.
- Favorable supply and demand fundamentals. On the one side, there is almost an insatiable global demand for yield, fueled in part by central banks all over going all out on monetary stimulus, thereby driving down and holding down sovereign yields. On the other side, net new issuance of high-yield debt is low. Rising demand and limited supply equals higher high-yield prices.
- Stronger equity markets. Merger & acquisition deals and initial public offerings (IPOs) are heating up, as high-quality corporations look to put some of their cash to work to fuel growth in a low-growth environment and high-yield companies seek to pay down debt with opportunistic equity issuances. Increases in M&As and IPOs tend to be positive for high-yield issuers, particularly those on the higher end of the speculative rating chain, as debt gets bought out or repriced at higher levels.
As mentioned at the start, it would not be surprising for high-yield’s run to pause at some point, especially if 10-year Treasury yields head back to 2%. This spread narrowing will result in good relative performance compared to higher quality fixed-income asset classes but will temper absolute returns. It is also important to remember that as spreads tighten toward 400 basis points (and potentially beyond), high-yield’s interest-rate sensitivity will increase and its credit (or equity) sensitivity will decrease. Credit will always be an important part of the high-yield equation but for the first time in many years, high-yield investors may need to keep one eye on the Treasury market.
But given how well the high-yield market has performed so far, it’s hard to complain about a slowdown. And with the four aforementioned forces very much in place, high yield would appear to still be a very good place for yield-oriented investors.