Fixed Income Blog

Wary of High Yield? Three Reasons Not to Be

29 May 2018

4 min read

Gershon M. Distenfeld, CFA | Director—Income Strategies

Will Smith, CFA| Director—US High Yield

High-yield investors bracing for a downturn in 2018 can relax. By some metrics, high-yield companies have rarely looked better. The way we see it, investors who do their homework can still profit in this environment.

After a strong 2017, high-yield bonds have struggled this year as US Treasury yields spiked and inflation potential stirred up fears that the Federal Reserve may raise borrowing costs more aggressively. With the US credit cycle in its 10th year and credit spreads—the extra yield high-yield bonds offer over comparable government debt—near record lows, some investors are no doubt asking themselves whether high yield’s potential return is worth the risk.

The answer, as far as we’re concerned, is yes. What makes us so sure? Simply this: in high yield, there are three warning signs that usually precede trouble—and none of them are flashing red yet. Let’s take a closer look.

Warning Sign No. 1: When Leverage Ratios Are High and Rising

Financial leverage is a lot like the water in a major river: when it’s high and rising, we start to worry—especially if we’re late in the credit cycle. But over the past few years, leverage has been declining in the high-yield market, leaving it less vulnerable to today’s rising-rate and late-cycle environment.

Energy companies are one reason for this. Many went on a borrowing binge earlier in the decade when commodity prices were high. Since the collapse of prices in 2014 and 2015, leverage in the sector has come down sharply. But leverage has been remarkably stable in the rest of the market too. This is partly because strong corporate earnings have vastly increased cash flow. But even after a 10% increase in EBITDA growth in 2017, companies simply haven’t been stretching to make large capital expenditures or buy back stocks (Display 1).

Leverage Is Down, Earnings Are Up

Through December 31, 2017
Historical and current analyses do not guarantee future results.
Source: Bloomberg, Morgan Stanley and S&P Capital IQ

In the US, many companies may be concluding that now isn’t the time to ramp up leverage. Yes, solid economic growth has been a boon for many issuers. And comprehensive US tax reform is likely to boost earnings this year. But after that, most companies expect the rate of earnings growth to slow and appear to be acting responsibly.

In Europe, leverage ratios are down, too, largely the result of stronger eurozone growth and improving corporate fundamentals.

Warning Sign No. 2: When “Junk” Issuance Dominates

CCC-rated “junk” bonds—the riskiest part of the high-yield market and the most vulnerable to rising rates—accounted for about 12% of new issuance in 2017—and just 3.5% in the first quarter of 2018. Compare that to 2007, when 28% of the high-yield bonds issued were rated CCC.

This is important, because when CCC-rated bonds dominate, it’s a sign that investors are hunting for yield and ignoring credit quality. This makes it possible for companies with fragile finances to borrow at attractive rates and leaves the market more vulnerable to a sharp drawdown.

What’s keeping a lid on CCCs? The volume of mergers and acquisitions (M&A) has been falling. More importantly, leveraged buyouts (LBOs)—the riskiest sort of takeover, which involves adding significant debt to corporate balance sheets—have been getting even rarer; last year, they accounted for 17% of debt issuance, compared with 29% in 2008. In the first quarter of 2018, just 1% of high-yield issuance came from LBOs (Display 2).

A Tale of Two Markets: Credit Quality in High Yield, Bank Loans

Percent of Issuance

As of March 31, 2018
Historical and current analyses do not guarantee future results.
Source: Morgan Stanley and S&P Capital IQ

As Display 2 also illustrates, we’ve seen the opposite trend in the high-yield bank-loan market. There, M&A and LBO activity is on the rise—largely because investors who see floating-rate loans as a remedy for rising rates are buying first and asking credit questions later. This is allowing companies to borrow without offering the types of lender protections typical in the high-yield market. It also makes loans less effective against rising rates.

Warning Sign No. 3: A Wave of High-Yield Defaults

Put simply, we’re not seeing anything that resembles a surge in defaults. Default volume ticked higher in the first quarter to 2.21%, with a single issuer (iHeartCommunications) accounting for more than half of the total.

Despite worries about inflation, the Fed is still signaling that it will hike rates gradually, and the global economy remains strong. If you’re betting that growth will continue this year and inflation will stay under control, you shouldn’t expect a wave of defaults any time soon. We expect a slight year-over-year rise, but for the rate to remain below average.

Today’s low default rates suggest high-yield bonds may not be as expensive as they first appear. As of mid-May, the yield to worst for the broad market—the lowest likely return you should get barring significant defaults—was hovering around 6.3%. For the global market, it was 6.1%. Few other assets can provide that type of income potential; those that can usually come with higher risk.

Don’t Ditch; Diversify.

None of this means that there won’t be rough patches ahead for high-yield bonds and other risk assets. With central banks slowly shifting out of the quantitative-easing era, markets are likely to remain volatile.

Our advice for surviving and continuing to profit in these conditions: Use a global, multi-sector strategy that mixes high-yield bonds with other income generators, such as emerging-market bonds and US securitized assets. And be selective. No matter the sector, a set-it-and-forget-it approach isn’t the way to go. But shunning high-yield bonds—one of the highest potential income generators out there—isn’t an option either.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

About the Authors

Gershon M. Distenfeld, CFA

Gershon Distenfeld is a Senior Vice President, Director of Income Strategies and a member of the firm’s Operating Committee. He is responsible for the portfolio management and strategic growth of AB’s income platform with almost $60B in assets under management. This includes the multiple-award-winning Global High Yield and American Income portfolios, flagship fixed-income funds on the firm’s Luxembourg-domiciled fund platform for non-US investors. Distenfeld also oversees AB’s public leveraged finance business. He joined AB in 1998 as a fixed-income business analyst and served in the following roles: high-yield trader (1999–2002), high-yield portfolio manager (2002–2006), director of High Yield (2006–2015), director of Credit (2015–2018) and co-head of Fixed Income (2018–2023). Distenfeld began his career as an operations analyst supporting Emerging Markets Debt at Lehman Brothers. He holds a BS in finance from the Sy Syms School of Business at Yeshiva University and is a CFA charterholder. Location: Nashville

Will Smith, CFA

Will Smith is a Senior Vice President and Director of US High Yield Credit. He is also a member of the High Income, Global High Yield, Limited Duration High Income, Short Duration High Yield and European High Yield portfolio-management teams. Smith designed and is one of the lead portfolio managers for AB’s Multi-Sector Credit Strategy, which invests across investment-grade and high-yield credit sectors globally. He leads the monthly High Yield portfolio-construction meeting, and is a member of the Credit Research Review Committee, which determines investment policy for the firm’s credit-related portfolios. Smith has authored several papers and blogs on high-yield investing, including one on the importance of using a probability-based framework to build better portfolios. He joined AB in 2012, and spent 2014 in London as part of the European High Yield portfolio-management team. Smith started his career with UBS Investment Bank, working as an analyst with the Credit Risk team and then later on the Fixed Income sales and trading desk. He holds a BA in economics from Boston College and is a CFA charterholder. Location: Nashville

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