The high yield bond market has posted a return of + 4.78% year-to-date (as of 10/31/14, as measured by the BAML US High Yield Master II Constrained Index). However, the continued uncertainty around the strength of global growth, coupled with evolving global central bank policies, has lead to an increase in market volatility. Left in the path of these recent episodes of volatility is a trail of dispersion of returns within the high yield bond market.
Ratings Return Dispersion
At the end of June year-to-date returns by rating buckets were relatively tightly packed. Double-B’s had returned +5.64%, single-B’s had returned +4.97% and CCC’s +5.73%. During the months of July through October market volatility increased and the dispersion of returns by rating categories increased dramatically. At the end of October double-B’s had returned +6.64%, single-B’s had returned +3.97%, and CCC’s only +1.46% (Chart 1)! We have not witnessed such dramatic underperformance by CCC’s relative to BB’s since 2011. 2011 included episodes of volatility and associated risk off trades largely due to the euro-zone sovereign debt crisis and the downgrade of U.S. treasury debt.
High Yield – Dispersion by Ratings: Returns by Ratings Buckets
Since the end of June, CCC’s have widened approximately +150 bps versus double-B’s and now stand at + 511 bps. The current spread relationship is relatively tight versus historical averages, but consistent with other periods of low defaults, 1994-1999 and 2003-2007 (Chart 2).
BB versus CCC spread
Sector Return Dispersion
Diving further, dispersion of returns has also been evident at the sector level. Once again sector returns were similar at the end of June. However, by the end of October dispersion of returns by sector had expanded significantly and the more cyclical, less defensive sectors had performed the worst. During the months of July thru October the worst performing sectors were energy -4.04%, basics -2.43%, and consumer cyclical -1.72%. Ouch! What performed well? Utilities returned +0.81% and consumer non-cyclical returned +0.45%. (Chart 3).
High Yield -Dispersion by Sector: Returns by Sector
Dispersion = Opportunity
Broadly speaking high yield fundamentals are solid. Corporate balance sheets remain healthy and supportive of the high yield bond market. Defaults are expected to remain well below long term averages. However, behind the ratings and sector return dispersion are dramatic individual issuer return dispersion. The market is far less tolerant of credits that disappoint on fundamentals. Complacency has been replaced with scrutiny…that’s good. Episodes of volatility will continue as global central bank policies evolve and drive the inevitable debate around implications for global growth.
Dispersion among many things sows the seeds of opportunity. Fundamentals really matter again. A strong, fundamental, bottom–up security selection investment process paired with disciplined portfolio construction, can uncover and capitalize on opportunities within the high yield bond market.
Have the concerns that captured the market’s attention during October already been banished to the distant past? For now, it certainly seems that way. Having touched an intra-session low of 1.86% on the 15th of October, 10yr US Treasury yields are back at 2.33%. While the S&P 500 has rallied 12% in an almost straight line from that same day to trade back up to record nominal highs.
Reasons for the rebound in sentiment include, better than expected Q3 earnings, economic data surprising positively and supportive central banks. Our sense is this exuberance can continue into yearend for a number of reasons.
Whilst October marked the end of quantitative easing from the US Federal Reserve (Fed), monetary policy around the world still remains exceptionally accommodative. Recent announcements and rhetoric from the world’s other two major central banks confirm that liquidity will increase as the combined central bank balance sheets of the Fed, European Central Bank (ECB) and the Bank of Japan (BOJ) will continue to expand. The ECB is looking to get its balance sheet back to levels seen in March 2012 (by adding another €1trn) and the BOJ is increasing its easing program by ¥10-20trn a year to ¥80trn.
With central banks remaining accommodative, the age old problem of zero cash rates around the world (and negative in Europe) continues to force investors to put money to work in search of yield. Year to date EPFR flow data for US High Grade bonds has only witnessed 1 week of outflows (back on the 15th Jan) while European Investment Grade fund flows can go one better by impressively having positive inflows every week this year. In both instances this trend looks likely to continue and although it is only one data point US High Yield last week received the third highest weekly inflow on record.
Finally from a seasonal aspect the last couple of months of the year is typically a good time to own risk assets. Taking US High Yield as an example and excluding the crisis years of 2007 and 2008, you need to go back to 2000 to have received a negative return during November and December.
All this combined leaves portfolios positioned in anticipation that the remaining few weeks of the year will be the season to be jolly.