Degustation or decompression for credit investors?
After a few small wobbles earlier in the year, the chase for yield has seemingly resumed, pushing US equities to record peaks and taking credit indices close to their most expensive post-GFC levels. This has seen many fixed interest managers reach further along the credit rating menu in the search for higher returns. The credit market is sufficiently diverse to cater to different investor tastes in terms of risk and return, however, behind the lure of the high yield area lie a number of not-so-hidden dangers of which every investor should be wary. In the following discussion we examine the case for spread decompression and the near term catalysts that render high yield debt more vulnerable.
One of these dangers is the evolving broader macroeconomic backdrop. For the first time in the post-GFC era, most of the world’s developed market central banks are on the path to policy normalisation. Critically, this is in the absence of a material pick-up in inflation and inflation expectations. In fact, both measures have actually fallen this calendar year as reflected in the chart below.
Chart 1: Inflation expectations have fallen
Historically, such declines in inflation expectations have been a negative for credit. This makes intuitive sense when we consider that inflation expectations also provide a gauge of sentiment towards future economic growth, which helps drive company revenues and how debt is serviced. It is important to make a distinction here between debt in the investment grade camp (BBB or above) and junk bonds (BB or below), also known as high yield. It is the latter camp that is the most sensitive to a shift in the economic landscape. The chart below illustrates that the spread between the difference in yield on junk and investment grade typically widens when inflation expectations fall i.e. junk bonds underperform.
Chart 2: Junk bonds underperform when inflation expectations fall
It is also important to consider that risks can vary considerably within each credit rung of the junk bond category. While many credit investors turn to this area in an attempt to boost yields, there are varying degrees of risks that do not necessarily compensate the investor with a higher return.
“The ability of CCC issuers to service their debt would be severely impeded if rates rose just 1.0%”
For example, in the CCC rating category the extra yield offered on issuers declines considerably as debt increases. On average, a company with three times leverage only offers an extra 10 basis points above a company with two times leverage. Further, the ability of CCC issuers to service their debt would be severely impeded if rates rose just 1.0%, to the extent that the interest payments would need to be funded by issuing further debt.
Structural change leads to risks at sector level
There are also varying vulnerabilities and growing risks at the sector level due to ongoing structural industry changes. These shifts cannot be weathered as easily by the high yield space when compared with their investment grade counterparts, given the former lacks the same financial flexibility. Further, if we are at the late stages of the US economic cycle, the impact of such changes are likely to be amplified by cyclical headwinds.
Delving deeper, while the energy sector faces its own challenges from weaker oil prices, the telecommunications and consumer spaces are looking increasingly concerning. For example, telecommunications are enduring a significant drop in the price of their services. This is evident in the Wireless Services Price Index, which has fallen by 11% in the six months to the end of June. While the reaction has been relatively muted in high yield telecommunications credit so far, the negative impact can be seen much more clearly in equities.
Charts 3 & 4: High yield telecommunications vulnerabilities increase as service prices plunge
The consumer-orientated areas are also a worry as supermarkets and food have more recently joined the longer term weakness in broader retail. This follows on the back of the Amazon-Wholefoods acquisition announcement, reflecting the growing threat of disruption from online retailers on more traditional distribution channels.
High yield (junk) bonds to underperform
With these factors in mind, we believe the high yield credit area is much more vulnerable than its investment grade counterpart. As such, we have positioned our alpha portfolios to benefit from the underperformance of junk bonds. This is achieved through buying protection on high yield indices and selling protection on safer investment grade credit. By selling protection on investment grade, the cost of our high yield trade is reduced. In turn, the trade performs well if we see a widening of high yield spreads versus investment grade. We see this as a reasonable probability of occurring in the near term. In turn, this is a relatively defensive approach that aims to protect portfolios, as well as offer a more active alternative that can still deliver returns when more conservative credit outperforms.
Within our yield focused funds we advocate for a more diversified approach to generating regular income by looking beyond credit markets and gain exposure to Australian shares that are generating consistent dividends. The Australian share market has established a remarkably reliable track record of delivering dividend yields of around 4% since 1982 and presents a suitable complement to a portfolio of high grade credit and corporate debt. With this approach investors can mitigate the exposure to risks that are gathering steam in parts of the credit spectrum.