Global growth concerns led by the continued uncertainty around the severity of the slowdown in China have pressured risk assets. Risk has repriced. The high yield market has not been immune and has now posted four consecutive months of negative returns for the first time in over 20 years, yields recently traded above 8.00% with a spread of 650 bps*. Yield has returned to the high yield market. The high yield market was first pressured by energy and commodity-related sectors, but recently negative price returns have broadened to include many sectors including Telecom and Media. Yields are now higher than any time since 4th quarter 2011.
The spread over treasuries in the high yield market is to primarily compensate investors for loss due to default experience. Excess spread is the spread that remains after loss; the more excess spread the better. Excess spread can also be considered a cushion for investors for unexpected loss due to higher defaults or perhaps lower recovery rates. Excess spread should not be zero. As with all risk assets, excess spread should exist for unexpected volatility events that generally impact risk assets to a greater degree than risk free assets. Various studies have shown that average excess spread for the high yield market over the last 25 years has been in the range of 250-300 bps. Assuming the current annual trailing twelve month default rate of 2.3% with a historical average 40% recovery, current excess spread at recent trading levels is 512 bps**; well above long term averages. Current spreads are forecasting a much higher level of defaults of 5-6%. Or said another way, spreads have considerable cushion to absorb much higher defaults.
Value Versus Other Credit Markets
All credit markets have been pressured recently, however high yield has cheapened considerably versus other credit markets. High yield spreads relative to investment grade and emerging market credit markets are now above historical median, but have only traded meaningfully above the median around U.S. recessions. 83% of high yield issuers are domiciled in the U.S. and credit fundamentals are most impacted by U.S. economic activity, as such it follows that high yield would underperform less levered investment grade and emerging credit markets during U.S. recessions.
Developed Markets Focused
Negative return years in the high yield market are rare, occurring only five times in the last 29 years and have most often occurred around U.S. recessions, 1991, 2001 and 2008. The high yield market is a developed markets credit market. As previously mentioned, the market is 83% U.S. domiciled while the remaining issuers are domiciled in G10 countries. High yield issuers do have cash flow exposure to emerging markets primarily in the energy and commodity sensitive issuers, but broadly speaking cash flows are dominated by developed markets. One item not debated is where the growth is in the global economy. Developed markets are growing faster than emerging markets and as we are entering a Fed tightening cycle, no U.S. recession is expected.
Valuations Have Decoupled from Fundamentals
Uncertainty around the severity of the slowdown in China and the resulting impact on global growth has increased risk to all risk assets including the high yield bond market. Current spreads imply a much more aggressive default experience leaving spreads significantly wider than previous periods of similar defaults. High yield has significantly unperformed other credits markets despite the relative strength of developed market economies while revenue and cash flows continue to show modest growth and are supportive of healthy fundamentals.
*all numbers are sourced from BaML Index
**current spread – default rate (1-recovery rate), 650 – 230 (1-.40) = 512 bps