Valuations the key indicator in high yield
If extreme measures to contain Covid-19 are successful, we believe the impact will be brutal but relatively short. There’s no question first-quarter gross domestic product will be weak, the second quarter likely negative and the third quarter weak and possibly negative—all of which affects high yield and all risk assets. Have the markets declined enough to discount the coming economic weakness? It is possible, but at this point, too soon to tell.
High yield also is being hit by the fall in oil prices, a consequence of falling virus-related demand as well as a price war between OPEC and Russia. This is impacting oilfield services, exploration and production, and midstream services that process, store and transport the product. The good news is lower prices support consumers and other economic sectors. Also, our portfolios for some time have been underweight the more volatile oilfield services and exploration/production sectors and overweight the less volatile midstream sector.
Some thoughts and our current assessment on high yield:
- As we entered this downturn, we already moved to an underweight position in high yield from a sector perspective across our Federated Hermes multisector bond portfolios. Our thinking well before this crisis came to light was that the high-yield valuations made the market vulnerable to unknown risks.
- Credit spreads—the difference between Treasury yields and yields on corporate bonds of comparable maturities—have widened significantly from roughly 400 basis points to over 900 basis points. Given this jump, our sector allocations remain underweight but we are evaluating not if, but when to start layering in additional high-yield exposure. While spread movements over the next weeks and months are impossible to predict, we are fairly certain that within two years, credit spreads will be tighter. As an aside, looking at month-end data since 1986, high-yield spreads have moved above 900 basis points only four times: September 1990; November 2000; July 2002 and September 2008. In each case, they continued higher but one year later, were lower. The move back over 900 basis points in 2002 was brief, peaked at 1,080 and, while waiting for the ultimate recovery, investors captured a healthy amount of coupon income.
- Our experience managing through multiple periods of market turmoil repeatedly has shown us that liquidity is available but it comes at a price. One of the reasons the high-yield market is moving aggressively lower is that active high-yield managers (such as ourselves) are seeking liquidity to meet redemptions. At some point Federated Hermes multisector funds want to provide that liquidity. As a reminder, our sector committee moved to overweight high yield in October 2008, experienced an extremely painful six weeks, but then were rewarded with strong long-term performance.
- Negative thinking to the extreme is to be expected. Human nature tends to take current conditions and do a straight-line projection—down—into the future. No one will ever go on a cruise ship again! Of course, in the real world events are dynamic. Markets aren’t factoring in policy changes, central bank action, positive news about virus treatments and prevention—these are what turn a seemingly bleak situation around.
Valuation is our key indicator. Our Federated Hermes multisector committee moved to an underweight position in high yield in late 2006 based on valuations and were eventually rewarded. We went overweight high yield in late 2008 based on valuations and were eventually rewarded. Early this year, based on valuations, we moved to underweight and have been rewarded. Valuation is a terrible timing tool, but it’s an extremely reliable indicator when it comes to avoiding purchases when spreads are tight and selling when spreads are wide.
The human and economic suffering related to Covid-19 is enormous and still unfolding. But when it comes to extreme investment challenges, we have been here before and—as always—are putting all of our experience and resources to work to support investors throughout this fast-evolving situation.