Global high yield markets are off to the races this year and with 6.47% already in the books it is no surprise that clients are asking us if we are still a buyer. In order to answer this, perhaps it is best to start by reviewing how we got here and determine what has driven this strong performance.
Valuations gradually cheapened over the course of last year before spiking in Q4 as concerns surrounding global trade and slowing economic growth escalated. After a dismal end to 2018, we entered the year with high yield spreads and yields at 536bps and 7.42% respectively; the highest level since plunging oil prices clobbered US HY spreads three years ago. Investors seemingly piled into high yield bonds to take advantage of these valuations, as evidenced by returns YTD of 6.95% for USHY and 4.93% for EHY, despite the asset class fundamental picture not having changed very much over the period. Third and fourth quarter earnings results were good, especially in the US, and credit metrics such as net leverage and interest coverage remained stable. At the same time, default rates at the end of February for the last twelve months remain benign at 1.11% for the US and 0.97% in Europe. If fundamentals haven’t driven the market higher, then what has?
The answer is technical conditions. Or, to put it simply, supply versus demand. In the first two months of 2019 high yield fund inflows exceeded €10bn. As for supply, the backdrop has also been extremely supportive. The high yield bond market has shrunk, with the gross supply of new issues down by about 40% versus the prior year in 2018. Whilst the primary market has picked up somewhat to a relatively normal pace this year in the US high yield market (11% lower than last year for the YTD at the end of February), there is still a dearth of high yield issuance in Europe. Combine this with the fact that rising stars have outweighed fallen angels over the past year and it is easy to see that the supply of high yield bonds is shrinking.
The key question is whether or not the market’s strong performance can continue. On the basis of technicals, we think that it can. To us, the asset class still seems under-owned. Most clients we speak to have been sticking to the lower end of their target high yield allocation ranges and this seems to be supported by fund-level data which shows that investors pulled more than $67bn from US high yield funds over the past 3 years. Compare this to the lead up to the Global Financial Crisis, when money was still flowing into the asset class, and it suggests that asset allocators are currently being cautious and still have plenty of room to add to high yield.
At the same time, we expect that supply will remain subdued in 2019. One factor that drives issuance is high yield issuers’ refinancing requirements. As illustrated in Figure 1, there is not much debt maturing before 2021. As for M&A, we expect volumes could rise modestly, but most of the LBO deals are likely to show a continued preference for the leveraged loan market. For what it is worth, the M&A that we have seen recently has been positive for our market. Consolidation in industries such as payment services and telecoms is likely to lead to ratings upgrades for high yield bond issuers such as UNITY Media, UPC, WorldPay and Vantiv.
However, rising stars are not solely attributable to M&A. For now the high yield market continues to witness more credit leaving it than joining it, as rating agency upgrades have continued to exceed downgrades. In Europe, Peugeot and Huntsman were the latest issuers to attain investment grade ratings and we expect close to 7% of the European high yield market could be upgraded to investment grade over the next 12 months. In the US, over $25bn of bonds left the high yield market after both Moody’s and S&P upgraded HCA Healthcare to investment grade in January.
Given the high yield bond market’s torrid start to the year, you would be forgiven for being less enamoured of valuations. Furthermore, a more dovish tone from central banks suggests that the macro outlook is cooling. However, one thing is difficult to deny. Technicals are strong in the high yield market. With ever more of the world’s debt touching record low yields, they might have become even stronger.