High Yield: Oasis in search for yield?

Since early 2016, US HY default rates have experienced a sort of “mini –cycle”, peaking at the end of 2016. Nevertheless, the recent rise and fall movements appear mostly commodity driven: default rates would have remained fairly stable if energy and material sectors were excluded from calculations. Looking at default rates from a rating perspective, the picture looks benign with default rates of high quality speculative grade bonds (BB rated) moving to zero in the last couple of years, B rated bonds stabilizing between 0 and 1.5% and CCC-rated names falling remarkably.

Here we try to identify the main drivers of default rates in order to understand if the current low levels are sustainable and ultimately if the corporate bond market can still provide a valuable source of returns for investors.

We group the drivers into two major categories: short-term drivers and structural drivers. Among short-term drivers, we include the macroeconomic conditions; we observe that what is relevant for default rates is not the level of growth rate but more the divergence from long-term trends. The current conditions with growth rates close to potential growth (i.e. not much divergence from trends) are favourable. In addition, top-down financial conditions (access to credit, via bank loans and bond market) are crucial, as low rated companies are highly dependent on external funding and vulnerable to sudden changes in liquidity conditions and investors’ risk aversion. Looking at bottom-up financial conditions (i.e. discriminating among sectors), even in the most stretched areas, the stress appears contained. Supply-related factors are also relevant among the short term drivers of default rates. We do not see a major concentration of maturing debt; refinancing needs seem limited. We are more concerned about areas outside the HY space, such as the surging BBB swathe of debt. Downgrades or refinancing challenges could result in selected BBB issuers becoming HY. Financial conditions are crucial to keeping risks contained.

In identifying structural / long-term drivers for default rates, we observe that the current cycle of HY default rates in the aftermath of the great financial crisis continues to be the most benign since 1990. The current macro cycle could soon become the longest expansion on record in the US, thanks to the ultra-easy monetary policy, the benign inflation regime, and fiscal policy boost, which has prolonged the extension. From a long term perspective, the cost of funding becomes crucial: what would happen if interest rates were to rise? This could be negative for the high yield market. In case of a sharp rise of interest rates, systemic risks would increase, leading to a renewed default cycle.
The good news is that nominal and real rates, even if on an upward trend, are still low on historical basis, and likely to remain stable. In addition to the levels of real and nominal rates, the shape of the yield curve also could be a cyclical catalyst for defaults, and it is something to monitor as the slope has reached levels of “alert”.

In conclusion, from an investment strategy perspective, looking at short-term and long-term drivers of HY default rates, the outlook for the default rate cycle still appears benign, even considering its length, if positive macro fundamentals (growth to continue around potential) and favourable financing conditions persist.

In terms of investing, we view high yield corporate spreads as still reasonably priced given our outlook regarding defaults. With central banks moving away from tightening regimes, search for carry will persist, and high yield continues to offer a decent spread over US Treasuries. Global high yield should continue to perform, albeit at a slower pace than in the first quarter. We look for good companies at good prices. We look for opportunities across the whole rating scale and across all sectors but individual security selection is crucial for identifying value. Energy, one of the largest sectors represented in the US high yield market, is exposed to the oil price swings but given its heterogeneity, can offer attractive investment opportunities. Liquidity is a crucial factor to consider for high yield investors. We believe investors should monitor liquidity at the issue level, and, also rely on derivatives, such as credit default swaps to enhance the overall liquidity of portfolios.

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