Much of the volatility seen in the high-yield market during summer 2014 resembled what happened approximately a year earlier. That move down was an overwhelmingly retail phenomenon. Retail investors own more of the high-yield market than in the past – about 25% of the market, from as low as 14% a few years ago – and this is a major factor to consider. This makes sense, as investors have been seeking higher yields due to what is on offer in government bonds.
The problem is that the retail high-yield investor is often ‘hot money’. We have had two ‘mini panics’, one in May 2013 and one in the summer of 2014, but they arose from slightly different inputs. The first was when then Fed Reserve chairman Ben Bernanke first mentioned ‘tapering’ of QE purchases, and retail investors looked in their portfolios and just sold anything that looked like a bond. During these periods, institutional investors noticed nothing had fundamentally changed in the market, and filled in the gaps.
2004, not 2007
There is no question that the high-yield market has been particularly healthy for a number of years. Raw issuance numbers suggest the high-yield market has taken on a lot, but adjusting issuance as a percentage of the total size of the market shows we have only been bouncing on either side of the average long-term growth trend of 10%.
As for quality, if you look at new-issue leverage, companies are not overly leveraging balance sheets – it has been pretty constant at 4.5 times earnings (figure 1). Another common theme of today is refinancing. We constantly hear of lower-quality issues coming to the market, but the contrasts between today and 2007 are striking; in terms of new-issue composition, we are closer to 2004 than 2007 (figure 2).
The significant refinancing element is critical to why we feel as comfortable as we do. Fundamentally, credit costs are the main driver of outcomes in high yield. We have seen, and continue to see, improvements in credit costs. Refinancing is a key ingredient of this.
The current default rate is under 2% for the US and we would not be surprised if it drifted a little lower. It is already low enough to support even lower spreads than today’s. When would we get more nervous about a turn in the cycle? Not until the market starts anticipating a pick-up in defaults, and we do not see any reason for this yet.
The low yields in credit are overwhelmingly a function of low Treasury yields. If there is overvaluation, it is entirely in the interest rate element. Spreads are certainly tighter than long-term averages but, importantly, long-term averages do not mean a lot. The option-adjusted spread of the BofA Merrill Lynch High Yield Master II index of US issues was at 453 basis points in mid-November 2014 and Moody’s most recent published default rate is 1.9%. If you say the typical loss on a default is 60%, 60% of 1.9% is 114 basis points, leaving 339 basis points of excess credit compensation. In a world of low yields and low returns, investors will want to own an excess spread of 339 basis points. It is a different story if you expect defaults to come in at 4%. But we believe default rates will stay at the current level, or drift lower.
However, we believe Europe is overpriced. There is a lot of money trapped on the Continent buying high-yield assets with less sensitivity to valuations. It is compounded by the yield on the German Bund. Taking the BofA Merrill Lynch Euro High Yield index for comparison, European high-yield is 220 basis points tighter than the US market. Only about 70 basis points of this is spread, the rest is Bund against Treasury. Plenty of companies that issue in both markets price bonds 150 basis points tighter in Europe. These companies point to the Bund and say ‘the spread is the same’ – but this is not for us.
All this is before you get to the fact that most of the companies in Europe are operating in materially weaker markets than the US right now. On average, you have much better credit quality in the US, a higher Treasury base component, and a higher spread. There is every reason to underweight Europe.
MacKay Shields manages five fixed-income UCITs funds on behalf of Nordea Asset Management, and among these the Nordea 1 – Unconstrained Bond fund had a 58.8% weighting in high yield as of 31 October 2014. To be long high-yield has become something of a contrarian call. People have been bullish on high-yield over the past few years, but sentiment has turned. We do not mind this being the case; we would much prefer to be contrarian than having everyone agree with us. We have been through numerous cycles, with many periods of market noise in between. There are some key risks in the market, such as the marginal risk that Europe starts to unwind, but we are confident the fundamental story for high yield is intact.
Louis Cohen is a senior managing director of MacKay Shields’ global fixed income team