Over the past two weeks financial markets have begun to re-price a higher probability of a recession as slowing global growth, increasing trade concerns and signals from the inverting yield curve have all created more uncertainty on future fundamentals. Despite the recent pullback, solid corporate fundamentals and attractive valuations at the beginning of the year have helped drive US high yield market returns +9.56% year-to-date (as measured by the ICE BofAML US High Yield Constrained Index, HUC0). Corporate earnings and cash flows have moderated from peak levels, but corporate balance sheets are sound as improved cash flow and modest spending plans have kept leverage moderate. Solid fundamentals, along with defaults well below long term averages, have provided a good back drop for impressive investment performance.
Technical strength in the high yield market is as important as solid fundamentals in the short term. Continued Central Bank global easing has driven rates down around the world, to a greater degree abroad than in the US. Currently over 20% of the global aggregate bond index is now negative yielding. This has created strong demand for positive yielding US assets in general, and specifically the relatively higher yielding US high yield bonds. Demand for high yield has far outpaced supply, creating a supply shortfall of over $150 billion since the beginning of 2017, providing a level of support for bond prices. And in 2019, the market has experienced over $15 billion of mutual fund inflows through the end of July, following negative net flows each of the last two years and five of the last six. Anecdotally, we have seen modest increases in institutional investors’ high yield exposure as well.
Bonds Paid Down or Refinanced as Other Financial Instruments
Fund and client flows on technicals are minor, however, when compared to the impact from the natural demand from high yield investors needing to replace calls, tenders and maturities within their portfolios. Gross new issuances, while running ahead of last year’s significantly depressed levels, remain well below normal. In 2018, new issuances of $187 billion trailed total calls, tenders and maturities by over $43 billion. Many high yield companies have been deleveraging their balance sheets and thus reducing total outstanding debt. When they do refinance their bonds, they have done so increasingly with other investment instruments, primarily leveraged loans. For example, high yield issuer Clear Channel Outdoor recently issued $334 million of equity, $1,260 million of secured bonds, and a $2 billion term loan for proceeds to refinance over $3.4 billion of bonds, reducing the company’s outstanding bonds by $2.2 billion.
In addition, the use of proceeds from new issuances has been increasingly for refinancing purposes, with approximately two-thirds of new issues, and less so for merger & acquisition or leveraged buyout finance, which are sources of new supply for the high yield market. A significant portion of the M&A/LBO marketplace has moved to loan-only financing as attractive, less restrictive covenants, or so-called “cov-lite” loans, have been offered and found more compelling than bonds to issuers.
Rising Stars with Few Falling Angels
Finally, in 2019 to-date, rising stars, bonds upgraded from high yield to investment grade, have significantly outpaced fallen angels, or bonds downgraded from investment grade to high yield, with over $38 billion upgraded versus less than $5 billion in fallen angels through the end of July. Company behavior continues to be disciplined, with deleveraging of balance sheets as opposed to an increase in leverage that typically occurs in the late innings of a credit cycle.
What Could Change?
So what could change to weaken market technicals? Although many sell-side strategists forecast continued moderate issuance for the balance of 2019, an acceleration could happen if M&A activity picks up dramatically. In addition, fund flows are volatile and could reverse rather rapidly to net outflows as they have the first few days of August. Finally, in the event of an economic downturn, fallen angels may be sizable as 50% of the investment grade market, or nearly $3 trillion, is rated just above high yield at BBB. However, while some are facing secular stress to their business that will be exacerbated by cyclical pressures and are likely subject to downgrades, a “tidal wave” of fallen angels is not expected at the end of the cycle. A quarter of BBB rated bonds are rated BBB-, and only about 12% of the BBB- subset have negative outlooks with at least one of the three major rating agencies. In general, despite the rise in BBBs as a percentage of corporate investment grade bonds, fundamentals remain reasonable with companies generating significant cash flow with which they could use to deleverage if necessary to maintain an investment grade rating.
While the strength of technicals has been persistent and provided some support for the high yield market, technicals alone are not enough to support strong returns. Strong technicals, in conjunction with solid market fundamentals and reasonable valuations relative to current default levels and other asset classes, make high yield an attractive investment option.