- Global fund flows indicate High Yield bonds have seen extremely healthy inflows as investors continue to hunt for yield
- Relatively High yields continue to draw investors into the segment
- Low Debt-to-EBITDA reflects healthy underlying fundamentals after a period of deleveraging following the crisis
- Spreads indicate fair value, but a significant improvement in the economic environment could see the spread compress
- Absolute low yield does not adequately reward investors for taking on the risks inherent with the segment
- Default rates continue to rise above previous forecasts and leading indicators point towards weakness, but, an improvement of the economy could see default rates continue to remain sub-dued
- Refinancing risks are elevated, especially with the bulk of issues maturing in 2014-2016, a period where interest rates are expected to rise
- High Yield segment is relevant in a well diversified fixed income portfolio where it has the ability to significantly boost yields
- Consider safer and more stable High Yield bond funds in a risky and sometimes speculative segment
In a historically low interest rate environment, investors who seek the safety of bonds or who seek to generate yield on their portfolios rather than target price appreciation, in a turbulent period have found it difficult to locate yields that suffice in overcoming inflation. With inflation in Singapore measuring above 4% for over 20 months, investors have had to resort to investing in the riskier segments of fixed income in order to overcome one of the basic hurdle rates of investing.
The riskier segments of fixed income have thus seen large inflows in 2012 on a year-to-date (YTD) basis. According to fund flows tracking firm EPFR, Emerging Market debt witnessed USD 21.2 billion of inflows while High Yield saw USD USD 39.5 billion enter its segment as investors who seek yield have found the riskier segments of fixed income more appealing. Spurring on the demand for the riskier segments has also been their outperformance of their safer cousins thus far in 2012, with High Yield and Emerging Market bonds delivering returns of 9.7% and 12.9% respectively as compared to Global bonds’ 2.8% return (as of 30 August 2012).
In this article, we take a closer look at the High Yield segment which has caught the eye of investors with its high returns in recent times and its relatively attractive yields in a low rate environment, and highlight the investment case as well as risks relating to the segment.
Investment Case - Only If You Want Yield
The High Yield segment has performed well in recent times, rewarding investors who were invested in it with a total return of 33.30% since 2010 (as of 6 September 2012). Taking a look at our latest weekly bond market commentary (6 September 2012), with a current yield of 6.7%, the high yield segment’s yield is miles ahead of the safer segments of fixed income such as global bonds which offer a yield of just 2.1% (Chart 1), and partially explains why investors have been turning their attention to and continued to show high interest in this sector as indicated by EPFR’s fund flows data as well as the regular appearance of such funds in the Top Volume By Sales (Bonds) table on our website.
Chart 1: Current YTMs
What has made High Yield an interesting segment then, apart from offering yields higher than the traditional segments of fixed income, and thereby making it relatively more attractive just on yield alone?
A forthcoming reason for the focus on high yield by many investors apart from the attractive yields has been the fundamental improvement of the sector over the past few years. Following a period of over-leveraging, many companies in the US deleveraged their balance sheet in response to the financial crisis as well as to bolster their financial health given the excesses of the past in hopes of not repeating past mistakes. As seen in chart 2 below, total corporate debt in the US has been steadily declining over the past few years, with the sector having deleveraged as much as -27.7% from its recent peak in Q4 2007, implying that corporates today are in better shape than before, which is also supported by the important Net Debt to EBITDA ratio.
The Net Debt to EBITDA ratio is an important debt metric measurement of corporate health as it indicates the number of years a company would require in order to repay back its debt based on its earnings before interest, taxes as well as depreciation and amortisation, one of the purest forms of calculating earnings. As seen in chart 2 below, the ratio has been on a downward trend since 1Q 2010, falling from over 6.0x to a current ratio of approximately 3.26x, indicating that the corporates currently have low and sustainable levels of debt which bodes well for bond holders.
Chart 2: Corporate Deleveraging
With positive underlying fundamentals, to gauge the relative attractiveness of the High Yield segment we look at its spread over the US 5 year Treasury note. The spread represents the additional reward an investor would receive in compensation for investing in the riskier segment rather than in the safer US 5 year Treasury.
As seen in chart 3, the spread between the High Yield segment and the US 5 year Treasury note currently hovers at around 6% or (600bps), despite being the US 5 year Treasury being distorted by unprecedented monetary easing, roughly in line with its long term average since July 1996 which encapsulates a wide range of market conditions and a complete business cycle. Thus, with the current spread meeting its historical average, we are of the opinion that the segment is currently fairly valued in terms of its relative attractiveness.
Chart 3: Current Spreads Indicate Fair Value
However, with an improving economic environment on the back of stabilising conditions as well as central bank easing, there could be room for the spread to tighten to the range it was at when the economy was running at close to full steam during 1996-1998 and 2003-2007, when the spread was approximately 400bps.
Investment Risks - Low Absolute Yields & Refinancing Issues
While the case for investing in the High Yield segment does look interesting for investors hunting for yield in a period of low interest rates, the absolute low yields (looked at on a stand-alone basis), as well as potentially refinancing issues come 2015-2018 could have some detrimental impact to the segment.
While the current yield on the High Yield segment is attractive relative to the US 5 year Treasury, on an absolute basis, investors are currently investing in a segment whose yields are at historical lows (chart 4). With a long term average yield of 10.1%, the 6.66% current yield that investors can get suggests that the segment is expensive. The current yield represents a figure that is -344bps below its long term average, does not adequately reward investors for taking on the inherent risks associated with investing in junk/non-investment grade bonds and warrants attention from investors.
Chart 4: Below Historical Average Yields
The recent rise in default rates does not spell good news for investors in the segment. With recent monthly trailing-12-months default rates coming in approximately 20-30 basis points higher than previously forecasted, with August 2012 registering a 3.0% default rate, rising from a 2.1% figure seen at the beginning of the year according to Moody’s Investors Services. With a historical average default rate of 4.3%, the latest measurement of 3.0% remains significantly below its mean (chart 5). Coupled with leading indicators such as the upgrade-to-downgrade ratio (which measures the number of issues upgraded to downgraded, a ratio greater than 1 indicating more upgrades than downgrades) declining to levels (0.34) last seen in 2Q 2009, investors would be prudent to pay some attention to potential weakness in the high yield segment. However, as mentioned above, with an improving economic environment on the back of stabilising conditions as well as central bank easing, the default rate trend could be poised to continue its below-average trend.
Chart 5: Default Rates Displaying a Modest Uptick
In addition to the above, the mountain of high yield debt that is about to mature between 2014 and 2016 coincides with when interest rates are expected to rise (mid-2015 for now), which will see over USD 912 billion worth of high yield expiring between 2014-2016 exposed to a period of rising interest rates, making it all the more costlier for them to refinance their debts.
Chart 6: High Yield Maturities
The relative attractiveness of the High Yield segment cannot be denied when compared against the extremely low yields on offer in the safer segments of fixed income. However, the combination of historical low yields for the segment, rising default rates, weakening leading indicators and a heavy debt load to be refinanced in a time of expected rising interest rates does not make the popular segment risk free.
On a relative basis, given the low interest rate environment the world is stuck in, investors who’d like to continue their hunt for yield should continue to consider the segment for its yield, although they should be warned that the recent extremely attractive performance of the segment over the past two years should not be indicative of the future returns they could expect. Rather, the yield-to-maturity of the segment is more representative going forward.
Investors should remember that our recommended portfolios currently recommend a small portion of High Yield within a diversified fixed income portion of a portfolio, to boost yields in today’s low rate environment (table 1 below).
Table 1: Fixed Income Portfolio Allocation
|Source: iFAST compilations
While there might be a high yield bond fund for everyone, investors must do their work diligently and know the risks involved with investing in the segment as it might not suit one and all. Given the above, we recommend investors, who are searching for yield to look towards funds which are invested in the higher-rated and less speculative securities of this riskier fixed income segment such as our current recommended fund for global high yield exposure, Schroder Global High Yield.
Investors who wish to proportion their own High Yield exposure between the US and Asia, could consider our other recommended High Yield funds Threadneedle (Lux) US$ High Inc Bd ASH SGD and Fidelity Asian High Yield (SGD-Hedged) for targeted exposure to the US and Asian High Yield bond space respectively.
Investors who seek to invest in funds that are predominantly vested in the substantially riskier and highly speculative segments within junk bonds that offer relatively higher yields, such as Allianz US High Yield and Aviva Global High Yield bond fund could continue to do so should they decide the sky is as blue as the sea, but be warned, the weather can change quickly.
As investors hunt for yield, interest in high yield bonds surges [28 Aug 2012]
Bonds Weekly: High Yield Leads The Way [09 August 2012]
WISE Fund of the Week: Possibly the Highest Yielding Fund on the Platform? [20 July 2012]
WISE Fund of the Week: Ramp Up Your Yield With This High Income Fund! [11 July 2012]
A Beginner's Guide to Fixed Income Investing