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High Yield Bonds: Past the Lows, Reaching for the Highs
The markets have put in a substantial bounce since March but fear persists that they have assumed a return to normal too quickly. There are certainly meaningful concerns still stalking sentiment – the resurgence of COVID-19 being the main one. As long as it remains a case of firefighting the disease at a local level, then perceptions should persist that it remains under control.
Economic data should also remain a source of positive news. Re-imposing a total lockdown looks unlikely, meaning indicators could stay well above the depths they plumbed in April. The enormous monetary and fiscal stimulus that has been delivered should ensure that the recovery continues. The economy responded strongly to these forms of stimulus in 2009 and 2010 despite a heavily impaired banking sector. The continuation of the economic rebound should be sufficient to stabilise risk assets.
Figure 1: A Substantial Pick-Up from High Yield
Source: State Street Global Advisors, Bloomberg Finance L.P., as of 24 June 2020.
Why invest in high yield bonds?
For fixed income investors, this environment raises the issue of where to find returns. Sticking with heavy allocations to cash or government bonds means accepting low returns. Our strategy of favouring investment grade (IG) corporate paper has performed well, with the Bloomberg Barclays Euro Aggregate Corporate Total Return Index returning over 1.8% (to 24 June 2020) since we wrote ‘Credit Where Credit is Due’ in our 4 May 2020 Espresso.
However, spreads on IG corporates have compressed versus government bonds and, while still around 40bp wider than prior to the crisis, this looks like a reasonable premium given the less friendly corporate environment. This still represents a pick-up of around 150bp versus government bonds, so harvesting the carry remains one strategy, but given low outright yields, total returns will be limited. A more stable economic backdrop means that there are reasons to consider allocations to high yield:
- The high yield (HY) option-adjusted spreads (OAS) remain around 200bp wider than pre-crisis levels on the Bloomberg Barclays Liquidity Screened Euro HY Index. They are close to the wides of 2018, a time when the market got concerned over the impact of Fed rate rises on corporates. So entry levels are still favourable for those seeking an area of the market with some potential to perform.
- The yield to worst on the Bloomberg Barclays Liquidity Screened Euro HY Index is close to 4.5%. This is higher than for emerging market debt and only less than US HY. This means carry is strongly positive and, with the option-adjusted duration on the index at 3.7 years, yields would have to increase in excess of 100bp to eradicate the gains from the coupon.
- Company results will be challenging over the coming quarter as the true cost of lockdown becomes clear. However, central banks and governments have put in place favourable conditions for corporates to borrow. This has led to record levels of issuance, which should have improved the survivability of those firms. This should help to curtail insolvencies over the next six months.
- Issuance has been heavy with over EUR 8 billion of deals launched just in the past week, according to Bloomberg. There are few signs that the market is being overwhelmed by this supply, in part because the ECB continues to buy IG credit, which should help cascade funds into the HY market. The summer is typically a time when issuance activity starts to tail off before picking back up in September. So supply pressures should ease. Heavy primary market issuance is not all bad, though: it also creates opportunities as it makes it easier to acquire paper at a discount to its fair value.
- Large numbers of corporate downgrades are perceived as a risk to HY performance, as these ‘Fallen Angels’ (companies that lose their IG rating) enter the smaller index world of HY. However, tactical positioning by fund managers can actually turn this to a fund’s advantage – for some brief thoughts on this see An Update on High Yield Bonds.
In summary, the market is likely to continue to fret over a resurgence in COVID-19 but it is likely that the nadir for the economy, at least, has been passed. Much of this positive news has already been priced in by markets, meaning any continued narrowing of credit spreads can occur but is likely to be gradual.
Assuming a fairly stable market, the high level of coupon returns provided by HY should not be overlooked as a key contribution to portfolio returns.
How to play this theme
Investors can play the high yield bond theme described above with a SPDR ETF. To learn more about the fund, and to view full performance history, please follow the link below:
SPDR Bloomberg Barclays Euro High Yield Bond UCITS ETF (Dist)
Flows
European-Domiciled ETP Segment Flows (Top/Bottom , $mn)
European-Domiciled ETP Asset Category ($mn)
Sources: Bloomberg Finance L.P., for the period 19-26 June 2020. Flows are as of date indicated and should not be relied upon as current thereafter.
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Exp. Date: 30/06/2021