Investors have been in love with high yield since the recession hit, as this asset class offered them high levels of current income coupled with a capital appreciation trade. Even after three years since the depth of the market’s bottom, high yield continued to outperform in 2012 with JP Morgan’s High Yield Fund (for example) returning 14.5% for the year, compared to the S&P 500 which appreciated 13.4% in 2012 (excluding dividends). This outperformance was driven by a few primary items:
- Fed funds rates were near zero, so high yield spreads vs treasuries were attractive.
- Default rates for high yield issuers were near historic lows, fueled by the simple demand function of the equation—more investors were eager for higher yielding debt, allowing even the most speculative companies to refinance pending maturities.
- A slowly improving economy made fixed income the perfect asset class to own in a sub-trend growth environment.
So in February of 2013 it appears as though there is not a lot of juice left in the high yield trade. JP Morgan reports that the average price of the HY index (CDX.HY) is currently trading at $102.6 (as of 1/25/13). Barclay reports that the HY index currently has a 6.7% current yield to maturity, and a 6.1% yield to worst… some of the lowest levels in decades. It seems as though whenever we get close to the ~7% current yield on high yield, we get a pullback (but this is more of a technical point than a fundamental thesis). So when investors today put money in high yield assets, they are investing in speculative grade companies and in return, are expecting a total return of 5.6% (as capital appreciation is no more). Even with the ten-year at 2.6%, this doesn’t seem like the appropriate risk/reward trade. However, folks have been talking about a “bubble” in high yield for the past year, but to the asset class’s credit, nothing has “popped,” so to speak.
So is 2013 the year when we see a serious pullback in high yield credit? We are getting more and more constructive that the answer to that question will be yes, and this will be driven by a few factors:
- Although the Fed has communicated to the public that it will likely rates low until 2015, we have begun to see both mortgage rates and treasury yields widen over the past month. Mortgage rates began to creep up at the end of January, and the ten-year yield is now close to 2.6%. An improving economy has led investors to shift into equities. This trend will continue as the economy continues to heal—high yield bonds have no more room to move up, so as money moves into other asset classes in search for high returns, investors will abandon the currently low 5.6% return expectations in high yield.
- A continuation of this capital re-allocation theme is the individual investor. January saw record inflows into equity-only mutual funds, with money coming out of high yield funds and ETFs. This is a shift from the immense amount of inflows fixed income funds have seen over the past couple years. These capital flow shifts usually build upon themselves, so we would expect more fund flows going into equity mutual funds in the coming months.
- One of the most common (and public) “bullish equities” theses for 2013 from fund managers is the bet that equities will outperform because investors will not accept the low returns credit is offering them, and will look to stocks as the only place to generate a reasonable return. This is especially true large pension funds that must earn more than 5–6% to balance the billions of unfunded liabilities on their books. It also does not help the high yield asset class when Bill Gross published in his January Investment Outlook that credit could very well be overbought right now. These talking heads going public about their dislike in high yield will only accelerate the actions of points #1 and #2 above.
- Although this is not an immediate catalyst, but as yields widen out for high yield issuers, then the cost of debt for many companies will increase, hence making refinancings in 2013 and beyond less affordable. This will in turn increase the default rate, and widen out yields further, building upon itself.
The Market Realist Take
The Fed’s decision on September 18 to maintain its bond buying program resulted in a rally in stocks, and yields dropped. The Fed made the decision on the back of rising mortgage rates and concerns about the strength of the US recovery. Bond ETFs are seeing inflows as the overall market environment continues to support the high yield asset class. With default rates low, investors have been encouraged to keep or add to their holdings despite yields still being on the lower side. Although yields went slightly up in the first week of October on news of the first partial government shutdown in 17 years, the reaction in most equity and bond markets was mostly muted since they anticipate the shutdown won’t last much longer. However, a prolonged shutdown might change investor sentiment and also weigh on the fourth quarter GDP.
A recent five-part series on our website titled Shutdown dented high yield bond market, but rally may resume soon states that with any tapering postponed until at least December due to the government shutdown, the Fed will continue to boost the long end of the Treasuries curve, effectively providing price support for all fixed income classes. So high yield funds like the iShares iBoxx $ High Yield Corporate Bond Fund (HYG) and SPDR Barclays Capital High Yield Bod ETF (JNK) seem to be a relatively safe place to park cash. One can hedge interest rate risk for these securities by hedging via the iShares Barclays 20+ Yr Treasury Bond ETF (TLT). For an ETF with less credit risk than JNK or HYG, one can also invest in the i Shares IBoxx $ Invest Grade Corp ETF (LQD) or the iShares Core Total US Bond Market ETF (AGG). The latter two funds will have less credit risk, but more interest rate risk.
(Read more: Why MLPs provide excellent risk-reward for investors)
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