The high yield hunger games

In the wake of Trump’s election victory the market’s appetite for risk assets like equities and high yield credit has grown considerably. This is evident in the chart below that demonstrates spreads for US high yield are within 2% of their pre-GFC lows. We examine whether this hunger for the lower rung credit securities is really warranted and the dangers investors face in playing the high yield game.

Chart 1: High yield spreads near pre-GFC lows

Source: FactSet

“Issuers are increasingly constrained in terms of their capacity to repay their growing debt loads”

Amy Xie Patrick, Portfolio Manager, Income & Fixed Interest

If we explore the underlying company fundamentals, there are some mixed signals. There have been recent improvements in the ability of corporates to repay their debt (as measured by interest coverage ratios) for example. However, this appears to be driven more by cost-cutting rather than increases in revenue, as can be seen in Chart 2 and Chart 3 where the earnings growth rate in recent years has materially outpaced revenue growth. Meanwhile, total debt levels continue to rise at a similar pace to previous years (Chart 4). Furthermore, the rate of corporate reinvestment (Chart 5) continues to fall to near GFC levels as dividends and buybacks are prioritised. This suggests issuers are increasingly constrained in terms of their capacity to repay their growing debt loads and therefore limited in their ability to participate in any economic rebound.

Charts 2 and 3: Cost-cutting driving earnings growth rather than revenues

  

Source: Deutsche Bank

Chart 4: Total debt growth similar to recent years

Source: Deutsche Bank

Chart 5: Reinvestment rates continue to fall

Source: Deutsche Bank

Similarly, default and recovery rates are not encouraging. Ex-commodities, high yield defaults are increasing, while recovery rates have fallen to roughly 30% (significantly below their long-term average). This may be attributable to less stringent covenants on issuers or their debt being a more junior tranche than in previous years. Importantly, the deterioration suggests high yield has become a riskier proposition than in previous years.

Charts 6 & 7: Default and recovery rates are deteriorating

 

     

Source: Deutsche Bank

The aforementioned concerns are compounded by an outlook for tighter monetary policy. Given the enormous stimulus that has been delivered via central bank liquidity in recent years, it is not surprising to see the high degree of correlation between credit spreads and central bank security purchases (Chart 8). However, with the US Federal Reserve (Fed), European Central Bank (ECB) and Peoples Bank of China (PBoC) all embarking on a tightening path, or at the very least, a withdrawal from easing, the outlook for credit spreads is beginning to look less rosy.

Chart 8: Correlation between credit spreads and central bank liquidity

Source: Citigroup

Fixed interest investors exposed to the high yield sector have additional risks to consider. For example, according to S&P, ratings of B- or lower are 10 times more likely to suffer a payment default versus the rest of the high yield market. Further, as the economic cycle matures, the positive correlation between credit and equities tends to break down, as companies seek to defend share prices through re-leveraging and share buy-backs in the face of fading momentum in operating earnings.

A key driver of the high yield market in recent years has been a hunger for yield. In a low bond yield environment (or negative yield as is the case in some parts of Europe), investors have effectively bid down their return expectations and hence grown comfortable with a higher level of risk. This is particularly evident in the North American market and US high yield issuers have been capitalising on this dynamic for the last couple of years. However, it is important for investors to remember that pricing high yield securities is both a function of market pricing for long term government bonds and inflation expectations. With the Fed now clearly past its ‘lower for longer’ mantra and bonds being repriced to reflect a higher Fed Funds Rate, high yield spreads have been compressed to their cyclical lows versus investment grade credit (Chart 9) and the potential extra return to compensate for increased risk is limited.

Chart 9: High yield versus investment grade spread differential

Source: Bloomberg

That is ultimately the key issue in the high yield hunger games: as the risks increase you need the ‘odds ever in your favour’ to capture sufficient reward. If there is a market correction, the game can quickly and very painfully turn against you. During such periods, exposures to liquid highly-rated investment grade assets provide a valuable defence.

 

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